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INTRODUCTION
Foreign exchange risk (also known as FX risk, exchange rate risk or currency risk) is a financial
riskthat exists when a financial transaction is denominated in a currencyother than that of the
base currency of the company. Foreign exchange risk also exists when the foreign subsidiary of afirm maintains financial statements in a currency other than the reporting currency of the
consolidated entity. The risk is that there may be an adverse movement in the exchange rateof
the denomination currency in relation to the base currency before the date when the transaction is
completed. nvestors and businesses exporting or importing goods and services or making
foreign investments have an exchange rate risk which can have severe financial conse!uences"
but steps can be taken to manage (i.e., reduce) the risk
This risk usually affects businesses that export and#or import, but it can also affect investors
making international investments. For example, if money must be converted to another currency
to make a certain investment, then any changes in the currency exchange rate will cause that
investment$s value to either decrease or increase when the investment is sold and converted back
into the original currency.
n today%s world no economy is self&sufficient, so there is need for exchange of goods and
services amongst the different countries. 'o in this global village, unlike in the primitive age the
exchange of goods and services is no longer carried out on barter basis. very 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. 'o whenever a country buys or sells goods and services from or to
another country, the residents of two countries have to exchange currencies. 'o we can imagine
that if all countries have the same currency then there is no need for foreign exchange.
https://en.wikipedia.org/wiki/Financial_riskhttps://en.wikipedia.org/wiki/Financial_riskhttps://en.wikipedia.org/wiki/Currencyhttps://en.wikipedia.org/wiki/Exchange_ratehttps://en.wikipedia.org/wiki/Currencyhttps://en.wikipedia.org/wiki/Exchange_ratehttps://en.wikipedia.org/wiki/Financial_riskhttps://en.wikipedia.org/wiki/Financial_risk7/24/2019 final foreign exchange.docx
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NEED FOR FOREIGN EXCHANGE
et us consider a case where ndian company exports cotton fabrics to *'+ and invoices the
goods in *' dollar. The +merican importer will pay the amount in *' dollar, as the same is his
home currency. owever the ndian exporter re!uires rupees means his home currency for
procuring raw materials and for payment to the labor charges etc. Thus he would need
exchanging *' dollar for rupee. f the ndian exporters invoice their goods in rupees, then
importer in *'+ 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.
'ometimes it also happens that the transactions between two countries will be settled in the
currency of third country. n that case both the countries that are transacting will re!uire
converting their respective currencies in the currency of third country. For that also the foreign
exchange is re!uired. f we would have the single currency all in the world, then we wouldn%t
need forex...because each country has its own politics or several together, and each of the
country has its own incomes and outcomes etc.
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PARTICIPANTS IN FOREIGN EXCHANGE MARKET
1. CUSTOMERS
The customers who are engaged in foreign trade participate in foreign exchange market by
availing of the services of banks. xporters re!uire converting the dollars in to rupee and
imporeters re!uire 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. -ommercial 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. +s every time the foreign exchange bought or oversold position. The
balance amount is sold or bought from the market.
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3. CENTRAL BANK
n all countries -entral bank have been charged with the responsibility of maintaining the
external value of the domestic currency. enerally this is achieved by the intervention of the
bank.
4. EXCHANGE BROKERS
Forex brokers play very important role in the foreign exchange market. owever the extent to
which services of foreign brokers are utili/ed depends on the tradition and practice prevailing at
a particular forex market center. n ndia as per F0+ guideline the +0s 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 ndia
.
5. OVERSEAS FOREX MARKET
Today the daily global turnover is estimated to be more than *' 1 2.3 trillion a day. The
international trade however constitutes hardly 3 to 4 5 of this total turnover. The rest of trading
in world forex market is constituted of financial transaction and speculation. +s we know that the
forex market is 67&hour market, the day begins with Tokyo and thereafter 'ingapore opens,
thereafter ndia, followed by 8ahrain, Frankfurt, 9aris, ondon, :ew ;ork, 'ydney, and back to
Tokyo.
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The Fu!"#$% $& "he F$'e#( E)!h*(e M*'+e"
2. The foreign exchange market serves two functions> converting currencies and reducing risk.
There are four ma=or reasons firms need to convert currencies.
6. First, the payments firms receive from exports, foreign investments, foreign profits, or
licensing agreements may all be in a foreign currency. n order to use these funds in its home
country, an international firm has to convert funds from foreign to domestic currencies.
?. 'econd, a firm may purchase supplies from firms in foreign countries, and pay these suppliers
in their domestic currency.
7. Third, a firm may want to invest in a different country from that in which it currently holds
underused funds.
3. Fourth, a firm may want to speculate on exchange rate movements, and earn profits on the
changes it expects. f it expects a foreign currency to appreciate relative to its domestic currency,
it will convert its domestic funds into the foreign currency. +lternately stated, it expects its
domestic currency to depreciate relative to the foreign currency. +n example similar to the one in
the book can help illustrate how money can be made on exchange rate speculation. The
management focus on eorge 'oros shows how one fund has benefited from currency
speculation.
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a laptop computer purchase where using the forward market helps assure the firm that will won$t
lose money on what it feels is a good deal. t can be good to point out that from a firm$s
perspective, while it can set prices and agree to pay certain costs, and can reasonably plan to earn
a profit" it has virtually no control over the exchange rate. Bhen spot exchange rate changes
entirely wipe out the profits on what appear to be profitable deals, the firm has no recourse.
C. Bhen a currency is worth less with the forward rate than it is with the spot rate, it is selling at
forward discount. ikewise, when a currency is worth more in the future than it is on the spot
market, it is said to be selling at a forward premium, and is hence expected to appreciate. These
points can be illustrated with several of the currencies.
2D. + currency swap is the simultaneous purchase and sale of a given amount of currency at two
different dates and values.
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FACTOR AFFECTINGN EXCHANGE RATES
C$,,$-#" P'#!e%
-ommodities are inversely related to currency values in most cases. + commodity is a hard asset
class that investors flock to as a safe haven when currency values fall, so trading patterns can
emerge that temporarily affect exchange rates. The exception to this rule applies to economies
whose main industry is tied to a traded commodity. For example, the -anadian dollar moves in
correlation to @il prices" as oil rises, the value of the -anadian dollar rises with it.
I"e'e%" R*"e%
-entral 8anks play a pivotal role in affecting exchange rates. Bhen interest rates in one country
are higher than rates in another country, it offers lenders a chance to gain higher returns by
investing in the country with higher rates. igher interest rates attract foreign investment, and
when investors purchase a country$s currency, they will cause the exchange rate to rise.
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I&/*"#$ '*"e
nflation is the unseen destroyer of currency value, because high inflation relative to another
country will depreciate their currency. The effects are generally temporary, however, as inflation
will cause interest rates to rise in order to counter the inflationary impact on the economy. The
devalued currency may continue to stay at depressed values if interest rates are significantly
lower relative to other country$s currencies.
S"'e("h $& e!$$,
conomic factors affecting exchange rates include hedging activities, interest rates, inflationarypressures, trade imbalance, and euro market activities. rving fisher, an +merican 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.
@n the other hand, the purchasing& power parity theory relates exchange rates to inflationary
pressures. n its absolute version, this theory states that the e!uilibrium exchange rate e!uals the
ratio of domestic to foreign prices. The relative version of the theory relates changes in the
exchange rate to changes in price ratios.
overnment 0ebtovernment debt is public debt or national debt owned by the central government. + country
with government debt is less likely to ac!uire foreign capital, leading to inflation. Foreign
investors will sell their bonds in the open market if the market predicts government debt within a
certain country. +s a result, a decrease in the value of its exchange rate will follow.
Terms of Trade
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Eelated to current accounts and balance of payments, the terms of trade is the ratio of export
prices to import prices. + country$s terms of trade improves if its exports prices rise at a greater
rate than its imports prices. This results in higher revenue, which causes a higher demand for the
country$s currency and an increase in its currency$s value. This results in an appreciation of
exchange rate.
EecessionBhen a country experiences a recession, its interest rates are likely to fall, decreasing its chances
to ac!uire foreign capital. +s a result, its currency weakens in comparison to that of other
countries, therefore lowering the exchange rate.
METHODS OF 0UOTING RATE
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xchange rate is a rate at which one currency can be exchange in to another currency, say *'0
Es.7A. This rate is the rate of conversion of *' dollar in to ndian rupee and vice versa.
X-+: G*@T+T@:
0E-T :0E-T
H+E+8 *:T H+E+8 *:T
@I -*EE:-; F@E: -*EE:-;
There are two methods of !uoting exchange rates.
2) 0irect methods
Foreign currency is kept constant and home currency is kept variable. n direct !uotation, the
principle adopted by bank is to buy at a lower price and sell at higher price.
6) n direct method>
ome currency is kept constant and foreign currency is kept variable. ere the strategy used by
bank is to buy high and sell low. n ndia with effect from august 6, 2CC? all the exchange rates
are !uoted in direct method.
t is customary in foreign exchange market to always !uote 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
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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
!uote from another party and other party !uotes a rate. The party asking for a !uote is known as%
asking party and the party giving a !uotes is known as !uoting party.
The advantage of twoJway !uote is as under
i. The market continuously makes available price for buyers or sellers
ii. Two way price limits the profit margin of the !uoting bank and comparison of one
!uote with another !uote can be done instantaneously.
iii. +s it is not necessary any player in the market to indicate whether he intends to buy
or sale foreign currency, this ensures that the !uoting bank cannot take advantage by
manipulating the prices.
iv. t automatically insures that alignment of rates with market rates.
v. Two way !uotes lend depth and li!uidity to the market, which is so very essential for
efficient market.
K
n two way !uotes the first rate is the rate for buying and another for selling. Be should
understand here that, in ndia the banks, which are authori/ed dealer always, !uote rates. 'o the
rates !uoted& buying and selling is for banks point of view only. t 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
8uying 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.
I"'$-u!"#$
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-onsider a hypothetical situation in which +8- trading co. has to import a raw material for
manufacturing goods. 8ut this raw material is re!uired only after three months. owever, 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. f he buys the goods in
advance then he will incur heavy interest and storage charges. owever, the availability of
derivatives solves the problem of importer. e can buy currency derivatives. :ow any loss due
to rise in raw material price would be offset by profits on the futures contract and vice versa.
ence, the derivatives are the hedging tools that are available to companies to cover the foreign
exchange exposure faced by them.
De#"#$ $& De'#*"#e%
0erivatives 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 e!uities.
0erivatives are risk shifting instruments. nitially, they were used to reduce exposure to changesin foreign exchange rates, interest rates, or stock indexes or commonly known as risk hedging.
edging 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.
0erivatives have come into existence because of the prevalence of risk in every business. This
risk could be physical, operating, investment and credit risk.
0erivatives provide a means of managing such a risk. The need to manage external risk is thus
one pillar of the derivative market. 9arties wishing to manage their risk are called hedgers.
The common derivative products are forwards, options, swaps and futures.
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1. F$'*'- C$"'*!"%
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.
+ 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. :o money is exchanged until the future date.
+ 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. t may believe that today%s forward rate willprove to be more favourable than the spot rate prevailing on that future date. +lternatively, the
company may =ust want to eliminate the uncertainty 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 !uoted for a forward contract is not an estimate of what the exchange rate will be on the
agreed future date. t 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.
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Forward rate has two components.
'pot 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 *' 1 #
rupee rate as there is exchange control regulations prohibiting free movement of capital from #
into ndia. n case of *' 1 # rupee it is pure demand and supply which determines forward
differential.
Forward rates are !uoted by indicating spot rate and premium # discount.
n direct rate,
Forward rate spot rate L premium # & discount.
xample>
The inter bank rate for ?2stIarch is 77.
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77.
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+dvantages 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 when using forward contracts.
The contract can be drawn up so that the exchange takes place on any agreed working
day.
0isadvantages of forward contracts>
They are legally binding agreements that must be hounored 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 -ontract must still be honored
.
2. OPTIONS
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+n option is a -ontractual 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. *pon 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)
n return for a payment (premium)
@ption lasts for a certain period of time J the right expires at its maturity
@ptions are of two kinds
2.) 9ut @ptions
6.) -all @ptions
9*T @9T@:'
The buyer (holder) has the right, but not an obligation, to sell the underlying asset to the
seller (writer) of the option.
-+ @9T@:'
The buyer (holder) has the right, but not the obligation to buy the underlying asset from
the seller (writer) of the option.
Te% $& O"#$%
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+ -all @ption is an option to buy a fixed amount of currency.
+ 9ut @ption is an option to sell a fixed amount of currency.
8oth types of options are available in two styles >
2. The +merican style option is an option that can be exercised at any time before its expiry date.
6. The uropean style option is an option that can only be exercised at the specific expiry date of
the option.
O"#$ 'e,#u,%
8y buying an option, a company ac!uires 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.
xample>
+ company has a re!uirement to buy *'0 2DDDDDD in one months time.
Iarket parameters>
-urrent 'pot Eate is 2,
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8ut a call option with a strike rate of 2.
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B+T +E 'B+9'P
+ contract between two parties, referred to as counter parties, to exchange two streams of
payments for agreed period of time. The payments, commonly called legs or sides, are calculated
based on the underlying notional using applicable rates. 'waps contracts also include other
provisional specified by the counter parties. 'waps are not debt instrument to raise capital, but a
tool used for financial management. 'waps are arranged in many different currencies and
different periods of time. *' 1 swaps are most common followed by Mapanese yen, sterling and
0eutsche marks. The length of past swaps transacted has ranged from 6 to 63 years.
S* M*'+e" P*'"#!#*"#$%
'ince swaps are privately negotiated products, there is no restriction on who can use the market>
however, parties with low credit !uality 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. n the
*.'. many parties re!uire their counter parties to have minimum assets of 1 2D million. This
re!uirement has become a standardi/ed representation of Qeligible swap participantsR.
The following list includes a 'ample of 'waps Iarket 9articipants>
2. Iultinational -ompanies.
'hell, 8I, onda, *nilever, 9rocter S amble, 9epsi -o.
6. 8anks
8anks participate in the swap market either as an intermediary for two or more parties or as
counter party for their own financial management.
?. 'overeign and public sector institutions
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Mapan, Eepublic of taly, lectricity de France, 'allie Iae (*.'. 'tudent oan Iarketing
+ssociation).
7. 'uper nationals
Borld 8ank, uropean nvestment 8ank, +sian 0evelopment 8ank.
3. Ioney Ianagers
nsurance companies, 9ension funds.
The'e *'e *%#!*// "$ "e% $& %* "'*%*!"#$%
nterest Eate 'wap
-urrency 'wap
1. INTEREST RATE S7APS
The most common type of interest rate swaps are Qplain vanillaR E'. ere, one party +, agrees
to pay to the other party 8, cash flows e!ual to interest at a predetermined fixed rate on anotional principal for a number of years. 'imultaneously, + agrees to pay party 8 cash flows
e!ual to interest at a floating rate on the same notional principal for the same period of time. The
currencies of the two sets of interest cash flows are the same. Ioreover, only the difference in
the interest
payments is paid#received" the principal is used only to calculate the interest amounts and is
never exchanged.
t is an arrangement whereby one party exchanges one set of interest payment for another e.g.
fixed or floating.
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+n 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.
2. CURRENC8 S7APS
ach entity has a different access and different long term needs in the international markets.
-ompanies receive more favorable credit ratings in their country of domicile that in the country
in which they need to raise capital. nvestors are likely to demand a lower return from a domestic
company, which they are more familiar with than from a foreign company. n some cases a
company may be unable to raise capital in a certain currency.
-urrency 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.
+ currency swap transaction involves an exchange of a ma=or currency against the *.'. dollar. n
order to swap two other non&*.'. currencies, a dealer may need to arrange two separate swaps.
+lthough, any currency can be used in swaps, many counter parties are unable to exchange 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 utili/e the respective exchanged currencies.
The uses of currency swaps are summari/ed below>
owering funding cost
ntering restricted capital markets
Eeducing currency risk
'upply&demand imbalances in the markets
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F$//$#( *'e '#%+% *%%$!#*"e- #"h %*%
nterest rate risk
xchange rate risk
0efault risk
'overeign risk
Iismatch risk (for dealers only)
FUTURES
n a futures contract there is an agreement to buy or sell a specified !uantity of financial
instrument in a designated Future month at a price agreed upon by the buyer and seller.
+ Future contract is evolved out of a forward contract and posses many of the same
characteristics. n essence, they are like li!uid forward contracts. *nlike forward contracts
however, futures contracts trade on organi/ed exchanges called futures markets.
The characteristics of a future contract are
'tandardi/ation
The future contracts are standardi/ed in terms of !uantity and !uality and future delivery date.
Iargining
The other characteristics of a futures contract are the margining process. The margin differs fromexchange to exchange and may change as the exchange%s perception of risk changes. This is
known as the initial margin. n addition to this there is also daily variation margin and this
process is known as marking to market.
9articipants
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The ma=ority of users are large corporations and financial institutions either as traders or hedgers.
Futures are exchange traded
n futures market there is availability of clearing house for settlement of transactions.
CURRENC8 FUTURES
-urrency futures markets were developed in response to the shift from fixed to flexible exchange
rates in 2C42. They became particularly popular after rates were allowed to float free in 2C4?,
because of the resulting increased volatility in exchange rates.
+ currency future is the price of a particular currency for settlement in a specified future date. +
currency future contract is an agreement to buy or sell, on the future exchange, a standard
!uantity of foreign currency at a future date at the agreed price. The counterpart to futures
contracts is the future exchange, which ensures that all contracts will honored. This effectively
eliminates the credit risk to a very large extent.
-urrency futures are traded on futures exchanges and the most popular exchange are the ones
where the contracts are fungible or transferable freely. The 'ingapore nternational Ionetary
xchange ('IX) and the nternational Ionetary Iarket, -hicago (II) are the most
popular futures exchanges. There are smaller futures exchanges in ondon, 'ydney, Tokyo,
Frankfurt, 9aris, 8russels, urich, Iilan, :ew ;ork and 9hiladelphia.
P'#!#( $& Fu"u'e% C$"'*!"
Futures 9rice 'pot 9rice L -ost of -arrying (nterest)
-ost 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.
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n ndia there is no futures market available for the ndian -orporates to hedge their currency
risks through futures.
The advantages of Future -ontract
ow -redit Eisk> n case of futures the credit risk is low as the clearing house is the
counter party to every future.
earing> @nly small margin money is re!uired to hedge large amounts.
The disadvantages of Future -ontract
8asic Eisk> +s futures contract are standardi/ed they do not provide a perfect hedge.
Iargining 9rocess> The administration is difficult.
t is observed that a futures contract is a type of forward contract, but there are several
characteristics that distinguish from forward contracts.
'tandardi/ed Hs. -ustomi/ed -ontract >
Forward contract is customi/ed while the future is standardi/ed.
-ounter 9arty Eisk >
n case of futures contract, once the trade is agreed upon the exchange becomes the counter
party. Thus reducing the risk to almost nil. n case of forward contract, parties take the credit risk
to each other.
i!uidity >
Futures contract are much more li!uid and their price is much more transparent as compared
to forwards.
'!uaring @ff>
+ forward contract can be reversed only with the same counter party with whom it was
entered into. + futures contract can be reversed with any member of the exchange.
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-@:TE8*T@: @F 0EH+TH' : T E@BT @F F@EX I+EUT'.
The tremendous growth of the financial derivatives market and reports of ma=or losses associated
with derivative products have resulted in a great deal of confusion about these complex
instruments. +re derivatives a cancerous growth that is slowly but surely destroying global
financial marketsP +re people who use derivative products irresponsible because they use
financial derivatives as part of their overall risk management strategyP
Those who oppose financial derivatives fear a financial disaster of tremendous proportions a
disaster that could paraly/e the world%s financial markets and force governments to intervene to
restore stability and prevent massive economic collapse, all at taxpayers% expense. -ritics believe
that derivatives create risks that are uncontrollable and not well understood.
9eople have certain believes about derivatives which hampers the growth of the derivatives
market. They are>
0erivatives are new, complex, high&tech financial products.
0erivatives are purely speculative, highly leveraged instruments.
The enormous si/e of the financial derivatives market dwarfs 8ank -apital, Thereby
Iaking 0erivatives Trading an *nsafe and *nsound 8anking 9ractice.
@nly large multinational corporations and large banks have a purpose for using
derivatives.
Financial derivatives are simply the latest risk management fad.
0erivatives take money out of productive processes and never put anything back
@nly risk&seeking organi/ations should use derivatives
The risks associated with financial derivatives are new and unknown
0erivatives ink market participants more tightly together, thereby increasing systematic
risks.
This is what some people believe, but it%s not the case.
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+ctually the financial derivatives have changed the face of finance by creating new ways to
understand, measure, and manage financial risks. *ltimately, derivatives offer organi/ations the
opportunity to break financial risks into smaller components and then to buy and sell those
components to best meet specific risk&management ob=ectives. Ioreover, under a market&
oriented philosophy, derivatives allow for the free trading of individual risk components, thereby
improving market efficiency. *sing 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. 0erivatives allow for the efficient transfer of financial risks and can help to ensure that
value&enhancing opportunities will not be ignored. *sed properly, derivatives can reduce risks
and increase returns.
0erivatives also have a dark side. t is important that derivatives players fully understand the
complexity of financial derivatives contracts and the accompanying risks. *sers 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 organi/ation%s overall risk&
management strategy and be in harmony with its broader corporate philosophy and ob=ectives.
There is no need to fear financial derivatives when they are used properly and with the firm%s
corporate goals as guides.
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7HAT IS THE NEED FOR FOR7ARD EXCHANGE CONTRACT9
The risk on account of exchange rate fluctuations, in international trade transactions increases if
the time period needed for completion of transaction is longer. t is not uncommon in
international trade, on account of logistics" the time frame cannot be foretold with clock
precision. xporters 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.
n international trade there is considerable time lag between entering into a sales#purchase
contract, shipment of goods, and payment. n 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.
-onse!uently, buyers and sellers want to protect them against exchange rate risk. @ne of the
methods by which they can protect themselves is entering into a foreign exchange forward
contract.
E'U I+:+I:T FE@I X9@ETE%' 9@:T @F HB
f on the 2st Manuary 6DDD exporter signs an export contract. e expects to get the dollar
remittance during the Mune. :ow let%s assume that on first Manuary exchange rate between dollar
and rupee is 7A.43DD and due to the adverse fluctuation of exchange rate the actual rate in Mune is
7A.3DD so we can infer from the above that the export may lose 63 paisa per dollar. +s per
instrument available in ndia exporter may enter a forward exchange contract with a bank. Bhile
entering the contract with bank, bank will give him a forward rate for Mune adding the premium
to the spot rate of first Manuary. et suppose it is 7A.A7DD so exporter can earn C paise my
exchange rate between dollar and rupee is 7A.43DD and due to the adverse fluctuation of
exchange rate the actual rate in Mune is 7A.3DDD so we can infer from the above that the export
may lose 67 paisa per dollar. +s per instrument available in ndia exporter may either a forward
exchange contract with a bank. Bhile entering the contract with bank, bank will give him a
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forward rate for Mune adding the premium to the spot rate of first Manuary. et suppose its
7A.A7DD so exporter can earn C paisa may cancel and rebook the contract as many as times they
want.
IMPORTER:S POINT OF VIE7
et suppose on first Manuary an importer signs a deal with foreign party. e expects to pay the
bill in Iarch on first Manuary the exchange rate is 73.43DD and the importer expects that the
dollar will depreciate in the month of Iarch. 'o the importer will enter into the agreement with
bank for the forward exchange contract. The bank will give him the forward rate. f 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.
n ndia 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 minimi/e the risk due to the adverse
foreign exchange rate movement.
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RISK MANAGEMENT PROCESS
2. dentify the Eisks> as a group, list the things that might inhibit your ability to meet your
ob=ectives. ;ou can even look at the things that would actually enhance your ability to meet those
ob=ectives eg. a fund&raising commercial opportunity. These are the risks that you face eg. loss of
a key team member" prolonged T network outage" delayed provision of important information
by another work unit#individual" failure to sei/e a commercial opportunity etc.
6. dentify the -auses> try to identify what might cause these things to occur eg. the key team
member might be disillusioned with his#her position, might be head hunted to go elsewhere" the
person upon whom you are relying for information might be very busy, going on leave or
notoriously slow in supplying such data" the supervisor re!uired to approve the commercial
undertaking might be risk averse and need extra convincing before taking the risk etc etc.
?. dentify the -ontrols> identify all the things (-ontrols) that you have in place that are aimed at
reducing the ikelihood of your risks from happening in the first place and, if they do happen,
what you have in place to reduce their impact (-onse!uence) eg. providing a friendly work
environment for your team" multi&skill across the team to reduce the reliance on one person"
stress the need for the re!uired information to be supplied in a timely manner" send a reminder
before the deadline" provide additional information to the supervisor before he#she asks for it etc.
7. stablish your ikelihood and -onse!uence 0escriptors, remembering that these depend upon
the context of your analysis ie. if your analysis relates to your work unit, any financial loss or
loss of a key staff member, for example, will have a greater impact on that work unit than it will
have on the *niversity as a whole so those descriptors used for the whole&of&*niversity
(strategic) context will generally not be appropriate for the Faculty, other work unit or the
individual eg. a loss of 1?DDDDD might be considered nsignificant to the *niversity, but it could
very well be -atastrophic to your work unit.
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3. stablish your Eisk Eating 0escriptors> ie. what is meant by a ow, Ioderate, igh or
xtreme Eisk needs to be decided upon ahead of time. 8ecause these are more generic in
terminology though, you might find that the *niversity$s 'trategic Eisk Eating 0escriptors are
applicable.
generally speaking, any risk that is rated as igh or xtreme should have
additional controls applied to it in order to reduce it to an acceptable level. Bhat the appropriate
additional controls might be, whether they can be afforded, what priority might be placed on
them etc. is something for the group to determine in consultation with the ead of the work unit
who, ideally, should be a member of the group doing the analysis in the first place.
4. Iake a 0ecision> once the above process is complete, if there are still some risks that are rated
as igh or xtreme, a decision has to be made as to whether the activity will go ahead. There
will be occasions when the risks are higher than preferred but there may be nothing more that
can be done to mitigate that risk ie. they are out of the control of the work unit but the activity
must still be carried out. n such situations, monitoring the circumstances and regular review is
essential.
A. Ionitor and Eeview> the monitoring of all risks and regular review of the unit$s risk profile is
an essential element for a successful risk management program.
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Te% $& '#%+ # &$'e#( e)!h*(e
1. P$%#"#$ R#%+
The exchange risk on the net open F$'e)position is called the position risk. The position can be
a long#overbought position or it could be a short#oversold position. The excess of foreign
currency assets over liabilities is called a net long position whereas the excess of foreign
currency liabilities over assets is called a net short position. 'ince all purchases and sales are at a
rate, the net position too is at a net#average rate. +ny adverse movement in market rates wouldresult in a loss on the net currency position.
For example, where a net long position is in a currency whose value is depreciating, the
conversion of the currency will result in a lower amount of the corresponding currency resulting
in a loss, whereas a net long position in an appreciating currency would result in a profit. iven
the volatility in F$'e)markets and external factors that affect FX rates, it is prudent to have
controls and limits that can minimi/e losses and ensure a reasonable profit.
The ,$%" $u/*' !$"'$/%;/#,#"% $ $e $%#"#$ '#%+% *'e
D*/#(h" L#,#" Eefers to the maximum net open position that can be built up a trader
during the course of the working day. This limit is set currency&wise and the overall position of
all currencies as well.
Oe'#(h" L#,#" Eefers to the net open position that a trader can leave overnight J to
be carried forward for the next working day. This limit too is set currency&wise and the overall
overnight limit for all currencies. enerally, overnight limits are about 235 of the daylight
limits.
2. M#%,*"!h R#%+;G* R#%+
Bhere a foreign currency is bought and sold for different value dates, it creates no net position
i.e. there is no FX risk. 8ut due to the different value dates involved there is a QmismatchR i.e.
the purchase#sale dates do not match. These mismatches, or gaps as they are often called, result
in an uneven cash flow. f the forward rates move adversely, such mismatches would result in
losses. Iismatches expose one to risks of exchange losses that arise out of adverse movement in
the forward points and therefore, controls need to be initiated.
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The /#,#"% $ G* '#%+% *'e
I-##-u*/ G* L#,#" This determines the maximum mismatch for any calendar
month" currency&wise.
A(('e(*"e G* L#,#" s the limit fixed for all gaps, for a currency, irrespective of theirbeing long or short. This is worked out by adding the absolute values of all overbought and all
oversold positions for the various months, i.e. the total of the individual gaps, ignoring the
signs. This limit, too, is fixed currency&wise.
T$"*/ A(('e(*"e G* L#,#" s the limit fixed for all aggregate gap limits in all
currencies.
3. T'*%/*"#$ R#%+
Translation risk refers to the risk of adverse rate movement on foreign currency assets andliabilities funded out of domestic currency.
The'e !*$" e * /#,#" $ "'*%/*"#$ '#%+ u" #" !* e ,**(e-
2 Funding of Foreign -urrency +ssets#iabilities through money markets i.e. borrowing or lending
of foreign currencies
6 Funding through FX swaps
? edging the risk by means of -urrency @ptions
7 Funding through Iulti -urrency nterest Eace 'waps
4. Oe'*"#$*/ R#%+
The operational risks refer to risks associated with systems, procedures, frauds and human errors.
t is necessary to recogni/e these risks and put ade!uate controls in place, in advance. t is
important to remember that in most of these cases corrective action needs to be taken post&event
too. The following areas need to be addressed and controls need to be initiated.
Se('e(*"#$ $& "'*-#( *- *!!$u"#( &u!"#$% The execution of deals is a function
!uite distinct from the dealing function. The two have to be kept separate to ensure a proper
check on trading activities, to ensure all deals are accounted for, that no positions are hidden
and no delay occurs.
F$//$
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Se""/e,e" $& &u-% Timely settlement of funds is necessary not only to avoid delayed
payment interest penalty but also to avoid embarrassment and loss of credibility.
Oe'-ue !$"'*!"% -are should be taken to monitor outstanding contracts and to ensure
proper settlements. This will avoid unnecessary swap costs, excessive credit balances and
overdrawn :ostro accounts.
F/$*" "'*%*!"#$% @ften retail departments and other areas are authorised to create
exposures. 9roper measures should be taken to make sure that such departments and areas
inform the authorised persons#departments of these exposures, in time. + proper system of
maximum amount trading authorities should be installed. +ny amount in excess of such
maximum should be transacted only after proper approvals and rate.
5. C'e-#" R#%+
-redit risk refers to risks dealing with counter parties. The credit is contingent upon theperformance of its part of the contract by the counter party. The risk is not only due to non
performance but also at times, the inability to perform by the counter party.
The !'e-#" '#%+ !* e
C$"'*!" '#%+Bhere the counter party fails prior to the value date. n such a case, the
Forex deal would have to be replaced in the market, to li!uidate the Forex exposure. f there
has been an adverse rate movement, this would result in an exchange loss. + contract limit is
set counter party&wise to manage this risk.
C/e* '#%+ Bhere the counter party fails on the value date i.e. it fails to deliver thecurrency, while you have already paid up. ere the risk is of the capital amount and the loss can
be substantial. Fixing a daily settlement limit as well as a total outstanding limit, counter party&
wise, can control such a risk.
S$e'e#( R#%+ refers to risks associated with dealing into another country. These risks
would be an account of exchange control regulations, political instability etc. -ountry limits are
set to counter this risk.
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T8PES OF EXPOSURES IN FOREIGN EXCHANGE MARKET
There are ? types of exposures existing in a foreign exchange market.
1. T'*%*!"#$ e)$%u'e
Transaction exposures are the most common. 'uppose that a company is exporting in euro and,
while costing the transaction, materiali/es, i.e. the export is affected and the euros sold for
rupees, the exchange rate has moved to Es. 7D per euro. n 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 foreign currency
denominated receipts or payments.
2. T'*%/*"#$ e)$%u'e
Translation exposures arise from the need to translate foreign currency assets or liabilities into
the home currency for the purpose of finali/ing the accounts for any given period. + typical
example of a translation exposure is the treatment of foreign currency loans.
-onsider that a company has taken a medium term dollar loan to finance the import of capital
goods worth 1 2mn. Bhen the import materiali/ed, the exchange rate was Es. 7D per dollar. The
imported fixed asset was, therefore, capitali/ed in the books of company at Es. 7DD lacks, for
finali/ing its accounts for the year in which asset was purchased. owever, at the time of
finali/ation of accounts, exchange rate has moved to Es. 73 per dollar, involving translation loss
of Es. 3D lacs, in this case, under the income tax act, the loss cannot be written off" it has to be
capitali/ed by increasing the book value of fixed asset purchased by drawing upon the loan. The
book value of asset thus becomes Es. 73D lacs and conse!uently higher depreciation will have to
be provided for thus reducing the net profit. f the foreign currency loan is use for working
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capital. n 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
favorable. The translation exposure of course becomes a transaction exposure at some stage the
dollar loan has to be repaid by undertaking the transaction of purchasing dollars against rupees.
3. E!$$,#! E)$%u'e
8oth transaction and translation exposures are accounting concepts whereas economic exposure
is different than an accounting concept. + company could have an economic exposure to the euro
" rupee rate even if it does not have any transaction or translation euro currency " this will be
the case when its competitors are using uropean imports. f the euro weakens, the company
loses its competitiveness against the competitors and vice versa. enerally, all businesses have
economic exposures to exchange rates. conomic 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 affect the profitability over a longer time
span than transaction exposure.