ST.

GONSALO
GARCIA
COLLEGE

PROJECT ON:
FOREIGN EXCHANGE
MANAGEMENT

SUB:
 SUBMITTED TO:
MISS RUPALI
MEMBERS

ROLL NAMES REMARKS

NOS.
02 MANOJ

03 MUKESH
12 ALBINUS
41 DELSON
43 SHREERAJ
 INDEX

SR. PARTICULARS
NO
1 INTRODUCTION TO FOREIGN EXCHANGE

2
NEED FOR Foreign Exchange
3
Foreign Exchange Market
4
Four Steps in Risk Management
5
FORWARD CONTRACTS, FUTURES & CURRENCY OPTIONS
6
Currency Futures
7
Currency Options
8
Swap
9
Cross Rates
10 Conclusion
FOREIGN EXCHANGE

Introduction

Foreign Exchange, simply stated, means foreign money. Thus,

foreign exchange and near money instruments denominated in foreign
currency, are called foreign
Exchange. In other words, all claims to foreign currency payable
abroad, whether consisting of funds held abroad in foreign currency or
bill or cheques in foreign currency etc., fall in the category of foreign
exchange.
In India, foreign exchange has been given a statutory definition:

Def: Sec 2(b) of Foreign Exchange Regulation Act, 1973 states:

“Foreign Exchange” means foreign currency and includes:

1. All deposits, credits and balances payable in any foreign

currency and any drafts, traveler’s cheques, letter of credit
and bills of exchange, expressed or drawn in Indian currency
but payable in any foreign currency

2. Any instruments 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.

The need for Foreign Exchange

An example in this aspect would be apt to understand the need of

Foreign Exchange.

A Japanese company exports electronic goods to USA and invoices

the goods in US Dollars. The American importer will pay the amount in
US dollars, as the same is his home currency. However, the Japanese
exporter requires Yen i.e. his home currency for procuring raw material
locally and making payments for the labour charges incurred for the
purpose etc.
Thus, he would need exchanging US dollars for Yen. If the
Japanese exporter invoices his goods in Yen, then importer in USA will
get his dollars converted in Yen and pay the exporter. And therefore, it
can be inferred that in case goods are bought or sold outside the
country, exchange of currencies becomes necessary.
Foreign Exchange Market

Foreign Exchange market is in fact misnomer or misleading in as

much as there is no market place as such which can be called foreign
exchange market. However, it is a facilitating mechanism through
which one country’s currency can be exchanged i.e. bought or sold for
the currency of another country. It does not have any geographic
location. The foreign exchange market comprises of all the foreign
exchange traders who are connected to each other throughout the
world through telecommunication network. They deal with each other
through telephones, telexes, and electronic systems. With advent of
advanced technology like Reuters Money 2000-2, it is possible to
access any trader in any corner of the world within a few seconds. In
fact now deal can be done through electronic dealing systems that
allow bid and offer rates to be matched automatically through central
computers and thus transaction take place in jiffy.

Factors that contribute to the growth of Indian Forex Markets

Global Forex market has taken quantum jump and the Indian market
has followed suit.

Better communication network like telephones, telexes, SWIFT,

Reuters/Telerate system etc., have been made available to the forex
dealers and these have contributed to the speed and efficiency of the
market. Thus, they are able to generate larger turnover. Rigid and tight
exchange controls have been relaxed and the banks are completely
free to deal in the inter bank market as also, to some extent, in the
overseas market.

With opening up of the banking sector to private sector more

players have been added to the market. Also, many more foreign
banks have set up shops in India and those, which were already
operating, have established more branches. This has contributed to
higher foreign exchange turnover.

Banks have been allowed to have, albeit to a small extent, an

access to the foreign currency assets and liabilities. With limited
integration of Indian and overseas forex markets, banks have access to
the inter bank markets for conversion of forex funds into Indian rupees
and re-conversion of the same on a continuous basis has given the
fillip in the market.

The Liberalised Exchange Rate Management System and

freedom given to the corporates to book re-book and cancel forward
contracts so long they have the genuine exposure, have also
contributed to the increased inter-bank dealings and consequently
increase in the trading volume in the foreign exchange markets.

Four Steps in Risk Management

1. Understand the nature of various risks.

2. Define a risk management policy for the organization and
quantifying maximum risk that organization is willing to take if
quantifiable.
3. Measure the risks if quantifiable and enumerate otherwise.
4. Build internal control mechanism to control and monitor all
the risks.

Step 1 – Understanding Risks

Risks can be classified into five categories:

1. Price or Market Risk

2. Counter party or Credit Risk
3. Dealing Risk
4. Settlement Risk
5. Operating Risks

1. Price Risks or Market Risk

This is the risk of loss due to change in market prices. Price risk can
increase further due to Market Liquidity Risk, which arises when
large positions in individual instruments or exposures reach more than
a certain percentage of the market, instrument or issue. Such a large
position could be potentially illiquid and not be capable of being
replaced or hedged out at the current market value and as a result
may be assumed to carry extra risk.

2. Counter party Risk or Credit Risk

This is the risk of loss due to a default of the Counterpart in

honouring its commitment in a transaction (Credit Risk). If the
Counterparty is situated in another country, this also involves Country
Risk, which is the risk of the Counter party not honouring its
commitment because of the restrictions imposed by the government
though counter party itself is capable to do so.

3. Dealing Risk

Dealing Risk is the sum total of all unsettled transactions due for all
dates in future. If the Counter party goes bankrupt on any day, all
unsettled transactions would have to be redone in the market at the
current rates. The loss would be the difference between the original
contract rate and the current rates. Dealing risk is therefore limited to
only the movement in the prices and is measured as a percentage of
the total exposure.

4. Settlement Risk

Settlement risk is the risk of Counterparty defaulting on the day

of the settlement. The risk in this case would be 100% of the exposure
if the corporate gives value before receiving value from the
Counterparty. In addition the transaction would have to be redone at
the current market rates.

5. Operating Risks

Operational risk is the risk that the organization may be exposed to

financial loss either through human error, misjudgment, negligence
and malfeasance, or through uncertainty, misunderstanding and
confusion as to responsibility and authority.

Further operating risks could be classified as under:

• Legal
• Regulatory
• Errors & Omissions
• Frauds
• Custodial
• Systems

Legal

Legal risk is the risk that the organisation will suffer financial loss
either because contracts or individual provisions thereof are
unenforceable or inadequately documented, or because the precise
relationship with the counter party is unclear.
Regulatory

Regulatory risk is the risk of doing a transaction, which is not as per

the prevailing rules and laws of the country.

Errors & Omissions

Errors and omissions are not uncommon in financial operations.

These may relate to price, amount, value date, currency, and buy/sell
side or settlement instructions.

Frauds

Some examples of frauds are:

• Front running
• Circular trading
• Undisclosed Personal trading
• Insider trading
• Routing deals to select brokers

Custodial

Custodial risk is the loss of prime documents due to theft, fire,

water, termites etc. This risk is enhanced when the documents are in
transit.

Systems

Systems risk is due to significant deficiencies in the design or

operation of supporting systems; or inability of systems to develop
quickly enough to meet rapidly evolving user requirements; or
establishment of a great many diverse, incompatible system
configurations, which cannot be effectively linked by the automated
transmission of data and which require considerable manual
intervention.

Step 2 - Define Risk Policy

 Decide the basic risk policy that the organisation wants to have.
This may vary from taking no risk (cover all) to taking high risks (open
all). Most organisations would fall somewhere in between the two
extremes. Risk and reward go hand in hand.

Cost Center Vs. Profit Center

A cost center approach looks at exposure management as

insurance against adverse movements. One is not looking for
optimisation of cost or realisation but meeting certain budgeted or
targeted rates. In a profit center approach, the business is taking
deliberate risks to make money out of price movements.

Step 3- Risk Measurement

There are a number of different measures of price or market risk

which are mainly based on historical and current market values
Examples are Value at Risk (VAR), Revaluation, Modeling, Simulation,
Stress Testing, Back Testing, etc.

Step 4- Risk Control

Control of Price Risk

Position limits are established to control the level of price or market

risk taken by the organization. Diversification is used to reduce
systematic risk in a given portfolio.

Control of Credit Risk

Credit limits are established for each counter party for both Dealing
Risk and Settlement Risk separately depending upon the risk
perception of the counter party.

Control of Operating Risk

Establishment of an effective and efficient internal control structure

over the trading and settlement activities, as well as implementing a
timely and accurate Management Information System (MIS).

Tools to control operating risks

• Comprehensive Systems and Operations Manuals

• Proper Organizations structure and adequate personnel
 • Separation of trading function from settlement, accounting and
risk control functions.

• Strict enforcement of authority and limits

• Written confirmation of all verbal dealings
• Voice recording
• Legally binding agreements with counter parties ensuring
proposed transactions are not ultra vires.
• Contingency Planning
• Internal Audits
• Daily reconciliations
• Ethical standards and codes of conduct
• Dealing discipline

FORWARD CONTRACTS, FUTURES & CURRENCY OPTIONS

Forward Contract

The rate in the forward market is a price for foreign currency set
at the time the transaction is agreed to but with the actual exchange,
or delivery, taking place at a specified time in the future. While the
amount of the transaction, the value date, the payments procedure,
and the exchange rate are all determined in advance, no exchange of
money takes place until the actual settlement date. This commitment
to exchange currencies at a previously agreed exchange rate is usually
referred to as a Forward Contract.

Forward contracts are the most common means of hedging

transactions in foreign currencies. The trouble with forward contracts,
however, is that they require future performance, and sometimes one
party is unable to perform on the contract. When that happens, the
hedge disappears, sometimes at great cost to the hedger. This default
risk also means that many companies do not have access to the
forward market in sufficient quantity to fully hedge their exchange
exposure. For such situations, futures may be more suitable.

Example

Suppose XYZ Ltd needs US $ 3,00,000 on 1st May 2000 for

repayment of loan installment and interest. As on 1st December 1999,
it appears to the company that the US $ may be dearer as compared
to the exchange rate prevailing on that date, say US $ 1 = Rest. 43.50.
Accordingly, XYZ Ltd may enter into a forward contract with a banker
for US $ 3,00,000. The forward rate may be higher or lower than the
spot rate prevailing on the date of the forward contract. Let us assume
forward rate as on 1st December 1999 was US$ 1 = Rest. 44 as
against the spot rate of Rest. 43.50. As on the future date, i.e., 1st May
2000, the banker will pay XYZ Ltd $ 3,00,000 at Rest. 44 irrespective of
the spot rate as on that date. Let us assume that the Spot rate as on
that date be US $ 1 = Rest. 44.80

In the given example XYZ Ltd gained Rest. 2,40,000 by entering

into the forward contract.

Payment to be made as per forward

contract Rs.132, 00,000

(US $ 3,00,000 * Rs.44.00)

Amount payable had the forward contract

not been in place
Rs.134, 40,000
(US $ 3,00,000 * Rs.44.80)

Gain arising out of the forward exchange

Rs.240, 000
contract

Currency Futures

Outside of the interbank forward market, the best-developed

market for hedging exchange rate risk is the currency futures market.

In principle, currency futures are similar to foreign exchange

forwards in that they are contracts for delivery of a certain amount of a
foreign currency at some future date and at a known price. In practice,
they differ from forward contracts in important ways.

1. One difference between forwards and futures is standardization.

Forwards are for any amount, as long as it's big enough to be worth
the dealer's time, while futures are for standard amounts, each
contract being far smaller that the average forward transaction.
2. Futures are also standardized in terms of delivery date. The normal
currency futures delivery dates are March, June, September and
December, while forwards are private agreements that can specify any
delivery date that the parties choose. Both of these features allow the
futures contract to be tradable.

3. Another difference is that forwards are traded by phone and telex

and are completely independent of location or time. Futures, on the
other hand, are traded in organized exchanges such the LIFFE in
London, SIMEX in Singapore and the IMM in Chicago.

4. But the most important feature of the futures contract is not its
standardization or trading organization but in the time pattern of the
cash flows between parties to the transaction. In a forward contract,
whether it involves full delivery of the two currencies or just
compensation of the net value, the transfer of funds takes place once:
at maturity. With futures, cash changes hands every day during the life
of the contract, or at least every day that has seen a change in the
price of the contract. This daily cash compensation feature largely
eliminates default risk.

Thus, forwards and futures serve similar purposes, and tend to

have identical rates, but differ in their applicability. Most big
companies use forwards; futures tend to be used whenever credit risk
may be a problem.

Debt instead of forwards or futures

Debt -- borrowing in the currency to which the firm is exposed or

investing in interest-bearing assets to offset a foreign currency
payment -- is a widely used hedging tool that serves much the same
purpose as forward contracts.

An example:

Elizabeth sold Canadian dollars forwards. Alternatively she could

have used the Eurocurrency market to achieve the same objective. She
would borrow Canadian dollars, which she would then change into
francs in the spot market, and hold them in a US dollar deposit for two
months. When payment in Canadian dollars was received from the
customer, she would use the proceeds to pay down the Canadian
dollar debt. Such a transaction is termed a money market hedge.
 The cost of this money market hedge is the difference between
the Canadian dollar interest rate paid and the US dollar interest rate
earned.

According to the interest rate parity theorem, the interest

differential equals the forward exchange premium, the percentage by
which the forward rate differs from the spot exchange rate. So the cost
of the money market hedge should be the same as the forward or
futures market hedge, unless the firm has some advantage in one
market or the other.

The money market hedge suits many companies because they

have to borrow anyway, so it simply is a matter of denominating the
company's debt in the currency to which it is exposed that is logical.
But if a money market hedge is to be done for its own sake, as in the
example, the firm ends up borrowing from one bank and lending to
another, thus losing on the spread.

This is costly, so the forward hedge would probably be more

advantageous except where the firm had to borrow for ongoing
purposes anyway.
 Currency Options
Many companies, banks and governments have extensive
experience in the use of forward exchange contracts. With a forward
contract one can lock in an exchange rate for the future.

There are a number of circumstances, however, where it may be

desirable to have more flexibility than a forward provides. For example
a computer manufacturer in California may have sales priced in U.S.
dollars as well as in German marks in Europe. Depending on the
relative strength of the two currencies, revenues may be realized in
either German marks or dollars.

In such a situation the use of forward or futures would be

inappropriate: there's no point in hedging something you might not
have. What is called for is a foreign exchange option: the right, but not
the obligation, to exchange currency at a predetermined rate.

Definition

A foreign exchange option is a contract for future delivery of a

currency in exchange for another, where the holder of the option has
the right to buy (or sell) the currency at an agreed price, the strike or
exercise price, but is not required to do so. The right to buy is a call;
the right to sell, a put. For such a right he pays a price called the
option premium. The option seller receives the premium and is obliged
to make (or take) delivery at the agreed-upon price if the buyer
exercises his option. In some options, the instrument being delivered is
the currency itself; in others, a futures contract on the currency.
American options permit the holder to exercise at any time before the
expiration date; European options, only on the expiration date.

Example
 Steve of Jackson Agro just agreed to purchase 15 million worth of
potatoes from his supplier in County Cork, Ireland. Payment of the five
million punts was to be made in 245 days' time. The dollar had recently
plummeted against all the EMS currencies and Steve wanted to avoid
any further rise in the cost of imports. He viewed the dollar as being
extremely instable in the current environment of economic tensions.
Having decided to hedge the payment, he had obtained dollar/punt
quotes of $2.25 spot, $2.19 for 245 days forward delivery. His view,
however, was that the dollar was bound to rise in the next few months,
so he was strongly considering purchasing a call option instead of
buying the punt forward. At a strike price of $2.21, the best quote he
had been able to obtain was from the Ballad Bank of Dublin, who would
charge a premium of 0.85% of the principal.

Steve decided to buy the call option. In effect, he reasoned, I'm

paying for downside protection while not limiting the possible savings I
could reap if the dollar does recover to a more realistic level. In a
highly volatile market where crazy currency values can be reached,
options make more sense than taking your chances in the market, and
you're not locked into a rock-bottom forward rate. This simple example
illustrates the lopsided character of Options.

Swap

• A SWAP transaction between currencies A & B consists of a

SPOT purchase (sale) of a coupled with a Forward sale
(purchase) of A, both against B. The amount of one of the two
currencies is identical in SPOT and Forward
• The banks quote and does outright Forward deal with non-
bank customers. The Forward deals are done in inter-bank
market in the form of SWAP
• Assume that a bank buys Pounds one month Forward
against Dollars from a customer. It has thus created long
position in Pounds and short in Dollars.

If it wants to square it up, it will do as follows:

A Swap in which it buys Pounds Spot and sells one month

forward, thus creating an offsetting short Pound position one month
forward.

Coupled with a Spot sell of Pounds to offset the long Pound

position in Spot created in the above Swap.
 The reason for this is that it is very difficult to find counter
parties with matching opposite news to cover the original position by
an opposite outright forward.

Cross Rates

In case the price of one currency is not quoted angst the other
currency the parity between them is obtained by using an intermediary
currency. The rate thus obtained is called a cross rate and the principle
applied for obtaining the cross rate is called the chain rule.

Example:

Say in the Indian market the US dollar is quoted is at USD 1 =

35.8675/8725

In case the DM is quoted in New York as 1 USD = DM

1.5900/5910
1 DM = Rs.22.5582, If 1.5910DM= 1 USD and 1 USD =
Rs.35.8675 then the answer for 1DM would be = Rs.22.5540

Similarly, if the cross rate currency for any currency is known

then it is possible to arrive at the rate of the desired currency.
 CONCLUSION

RISK Management is an essential part of business

and should be viewed with Objectivity. It is neither a
license to print money nor is it a cause for getting
trapped in a Fear Psychosis, and should be viewed
with the same clarity of vision as, say, Production or
Marketing is viewed
Liberalization and removal of restrictions in
developed and developing countries have accelerated
geographical integration of foreign markets.
On 24th of august 2010 it was declared by central
government that India stands in 9th position in dealing
with foreign capital also Indian agricultural sector
plays an important role in foreign export