C r i t i c a l l e

`A

CAPSTONE PROJECT ON RISK MANAGEMENT IN FOREIGN EXCHANGE MARKET

SUBMITTED IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE AWARD OF THE DEGREE OF MASTER OF MANAGEMENT STUDIES OF

UNIVERSITY OF MUMBAI SUBMITTED BY SUMEET R.NIKAM SECOND YEAR(

RD

SEM! FINANCE

ROLL NO. " UNDER THE GUIDANCE OF PROF.CRS PILLAI MMS #$% &%'

PILLAIS INSTITUTE OF MANAGEMENT STUDIES AND RESEARCH PANVEL

ACKNOWLEDGEMENT

Successful completion of any work would be incomplete unless we mention the name of person who made it possible, whose guidance and encouragement served as a beckon of light and crowned my efforts success.

I own my profound gratitude to P()*+,,)(. CRS PILLAI for helping me during the research and providing me valuable insights. Their timely help & encouragement helped me to complete this project successfully.

I am also thankful to all those persons who have directly or indirectly helped me during the project report.

SUMEET NIKAM

CERTIFICATE

This is to certify that the project titled RISK MANAGEMENT IN FOREIGN EXCHANGE MARKET is successfully done by S!"##T $%"%&%'T 'I&%" in partial fulfillment of the degree of "asters in "anagement Studies with (I'%'C# speciali)ation for the academic year *****.

The work has not been copied from anywhere else and has not been submitted to any other !niversity+Institute for an award of any degree+diploma.

PROF.CRS PILLAI DR.G.VIJAYARAG VAN ,roject -uide .irector

DECLARATION

This is to certify that ,roject $eport entitled RISK MANAGEMENT IN FOREIGN EXCHANGE MARKET which is submitted by me in partial fulfillment of the re/uirement of "asters of "anagement Studies comprises of
4

my original work and due acknowledgement has been made in the test to all material used.

NAME OF THE STUDENT SUMEET RAMAKANT NIKAM DATE-

INDEX PAGE

S$.no 0

Title 1bjectives and $esearch methodology

,age 'o. 2

3 6 7 2 5

Introduction to (oreign #4change Currency Swaps Suggestion Conclusion :ibliography

5 78 96 97 92

CHAPTER 0

OBJECTIVES-& To study in detail complications about the foreign e4change market. $elevant concept and knowledge of foreign e4change market. (unctioning of foreign market related with Indian market.

 To study vol atility of foreign market. Study of strategy used in foreign market. Study method of Trade.

REASERCH METHODOLOGY-& P()./+0 R+1)23454)3 R+,+6(17 8+,423&

D656 C)//+154)3 A36/9,4, 638 I35+(:(+5654)3 R+,+6(17 D+,423

S#C1'.%$; .%T% .ata is collected from maga)ines, books, newspapers and through internet.

CHAPTER #

I35()8;154)3

(oreign #4change is the process of conversion of one currency into another currency. (or a country its currency becomes money and legal tender. (or a foreign country it becomes the value as a commodity. Since the commodity has a value its relation with the other currency determines the e4change value of one currency with the other. (or e4ample, the !S dollar in !S% is the currency in !S% but for India it is just like a commodity, which has a value which varies according to demand and supply. Transactions conducted in foreign e4change markets determine the rates at which currencies are e4changed for one another, which in turn determine the cost of purchasing foreign goods & financial assets. The most recent, bank of international settlement survey stated that over <=88 billion were traded worldwide each day. .uring peak volume period, the figure can reach upward of !S <3 trillion per day. The corresponding to 058 times the daily volume of ';S#. Initially, the value of goods was e4pressed in terms of other goods, i.e. an economy based on barter between individual market participants. The obvious limitations of such a system encouraged establishing more generally accepted means of e4change at a fairly early stage in history, to set a common benchmark of value. In different economies, everything from teeth to feathers to pretty stones has served this purpose, but soon metals, in particular gold and silver, established themselves as an accepted means of payment as well as a reliable storage of value. The lack of sustainability in fi4ed foreign e4change rates gained new relevance with the events in South #ast %sia in the latter part of 0==>, where currency after currency was devalued against the !S dollar, leaving other fi4ed e4change rates, in particular in South %merica, looking very vulnerable.

H)< 5) M6362+ R4,= 0. Identify $isk 3. %nalyse $isk 6. #valuate $isk 7. Treat $isk

C?%,T#$ 6 A36/9,4, 638 I35+(:(+5654)3 0. (oreig Currency Cash (lows 3. @ariability of Cash (lows 6. Time -aps 7. Currency ,ortfolio "i4 2. (i4ed and floating $ate 5. 1ffers currency analysis for multiple time frames, fundamental and technical analysis, articles and news.

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F4>+8 638 F/)65432 E>17632+ R65+, In a fi4ed e4change rate system, the government Aor the central bank acting on the governmentBs behalfC intervenes in the currency market so that the e4change rate stays close to an e4change rate target. Dhen :ritain joined the #uropean #4change $ate "echanism in 1ctober 0==8, we fi4ed sterling against other #uropean currencies Since autumn 0==3, :ritain has adopted a floating e4change rate system. The :ank of #ngland does not actively intervene in the currency markets to achieve a desired e4change rate level. In contrast, the twelve members of the Single Currency agreed to fully fi4 their currencies against each other in Eanuary 0===. In Eanuary 3883, twelve e4change rates become one when the #uro enters common circulation throughout the #uro Fone. E>17632+ R65+, ;38+( F4>+8 638 F/)65432 R+240+, Dith floating e4change rates, changes in market demand and market supply of a currency cause a change in value. In the diagram below we see the effects of a rise in the demand for sterling Aperhaps caused by a rise in e4ports or an increase in the speculative demand for sterlingC. This causes an appreciation in the value of the pound.

Changes in currency supply also have an effect. In the diagram below there is an increase in currency supply AS0GS3C which puts downward pressure on the market value of the e4change rate. FREE FLOATING

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 @alue of the currency is determined solely by market demand for and supply of the currency in the foreign e4change market. Trade flows and capital flows are the main factors affecting the e4change rate In the long run it is the macro economic performance of the economy Aincluding trends in competitivenessC that drives the value of the currency. 'o preGdetermined official target for the e4change rate is set by the -overnment. The government and+or monetary authorities can set interest rates for domestic economic purposes rather than to achieve a given e4change rate target. It is rare for pure free floating e4change rates to e4ist G most governments at one time or another seek to HmanageH the value of their currency through changes in interest rates and other controls. !& sterling has floated on the foreign e4change markets since the !& suspended membership of the #$" in September 0==3

S432/+ C;((+319 The country pegs to a major currency, usually the !. S. .ollar or the (rench franc A#4G(rench coloniesC with infre/uent adjustment of the parity. "any of the developing countries have single currency pegs.

F/+>4./+ L4045+8 ?4,&@&?4, S432/+ C;((+319 The value of the home currency is maintained within margins of the peg. Some of the "iddle #astern countries have adopted this system. A8A;,5+8 5) 4384165)(,

12

 The currency is adjusted more or less automatically to changes in selected macroGeconomic indicators. % common indicator is the real effective e4change rate A$##$C that reflects inflation adjusted change in the home currency visGIGvis major trading partners. M6362+8 */)65432 The Central :ank sets the e4change rate, but adjusts it fre/uently according to certain preGdetermined indicators such as the balance of payments position, foreign e4change reserves or parallel market spreads and adjustments are not automatic. I38+:+38+35/9 */)65432 (ree market forces determine e4change rates. The system actually operates with different levels of intervention in foreign e4change markets by the central bank. It is important to note that these classifications do conceal several features of the developing country e4change rate regimes. N++8 638 I0:)(5631+ )* F)(+423 E>17632+ M6(=+5, (oreign e4change markets represent by far the most important financial markets in the world. Their role is of paramount importance in the system of international payments. In order to play their role effectively, it is necessary that their operations+dealings be reliable. $eliability essentially is concerned with contractual obligations being honored. (or instance, if two parties have entered into a forward sale or purchase of a currency, both of them should be willing to honour their side of contract by delivering or taking delivery of the currency, as the case may be. W79 T(68+ F)(+423 E>17632+B (oreign #4change is the prime market in the world. Take a look at any market trading through the civilised world and you will see that everything is valued in terms of money. (ast becoming recognised as the worldBs premier
13

trading venue by all styles of traders, foreign e4change Afore4C is the <)(/8C, /6(2+,5 *4363146/ 06(=+5 with 0)(+ 5763 USD# 5(4//4)3 traded daily. (ore4 is a great market for the trader and itBs where Hbig boysH trade for large profit potential as well as commensurate risk for speculators. (oreign market used to be the e4clusive domain of the worldBs largest banks and corporate establishments. (or the first time in history, itBs barrierGfree offering an e/ual playingGfield for the emerging number of traders eager to trade the worldBs largest, most li/uid and accessible market, 37 hours a day. Trading fore4 can be done with many different methods and there are many types of traders G from fundamental traders speculating on midGtoGlong term positions to the technical trader watching for breakout patterns in consolidating markets. O::)(5;3454+, F()0 A();38 57+ W)(/8 1ver the last three decades the foreign e4change market has become the worldBs largest financial market, with over <3 trillion !S. traded daily. (ore4 is part of the bankGtoGbank currency market known as the 37Ghour interbank market. The Interbank market literally follows the sun around the world, moving from major banking centres of the !nited States to %ustralia, 'ew Fealand to the (ar #ast, to #urope then back to the !nited States.

T(63,*+( )* P;(176,432 P)<+(The primary function of a foreign e4change market is the transfer of purchasing power from one country to another and from one currency to

14

another. The international clearing function performed by foreign e4change markets plays a very important role in facilitating international trade and capital movements.

P()?4,4)3 )* C(+845J The credit function performed by foreign e4change markets also plays a

very important role in the growth of foreign trade, for international trade depends to a great e4tent on credit facilities. #4porters may get preGshipment and postGshipment credit. Credit facilities are available also for importers. The #uroGdollar market has emerged as a major international credit market.

P()?4,4)3 )* H+82432 F614/454+,J The other important function of the foreign e4change market is to provide

hedging facilities. ?edging refers to covering of e4port risks, and it provides a mechanism to e4porters and importers to guard themselves against losses arising from fluctuations in e4change rates. A8?63562+, )* F)(+423 M6(=+5 %lthough the foreign market is by far the largest and most li/uid in the world, day traders have up to now focus on seeking profits in mainly stock and futures markets. This is mainly due to the restrictive nature of bankGoffered foreign trading services. %dvanced Currency "arkets A%C"C offers both online and traditional phone foreignGtrading services to the small investor with minimum account opening values starting at 2888 !S.. There are many advantages to trading spot foreign e4change as opposed to trading stocks and futures. :elow are listed those main advantages. C)004,,4)3,%C" offers foreign e4change trading commission free. This is in sharp contrast to Aonce againC what stock and futures brokers offer. % stock trade can

15

cost anywhere between !S. 2 and 68 per trade with online brokers and typically up to !S. 028 with full service brokers. (utures brokers can charge commissions anywhere between !S. 08 and 68 on a round turn basis. M6(243, (+E;4(+0+35,%C" offers a foreign e4change trading with a 0K margin. In laymanBs terms that means a trader can control a position of a value of !S. 0B888B888 with a mere !S. 08B888 in his account. :y comparison, futures margins are not only constantly changing but are also often /uite si)eable. Stocks are generally traded on a nonGmargined basis and when they are, it can be as restrictive as 28K or so. #' 7);( 06(=+5(oreign e4change market trading occurs over a 37 hour period picking up in %sia around 37J88 C#T Sunday evening and coming to an end in the !nited States on (riday around 36J88 C#T. %lthough #C's Aelectronic communications networksC e4ist for stock markets and futures markets Alike -lobe4C that supply after hours trading, li/uidity is often low and prices offered can often be uncompetitive. N) L4045 ;: F /4045 8)<3(utures markets contain certain constraints that limit the number and type of transactions a trader can make under certain price conditions. Dhen the price of a certain currency rises or falls beyond a certain preGdetermined daily level traders are restricted from initiating new positions and are limited only to li/uidating e4isting positions if they so desire. S+// .+*)(+ 9); .;9#/uity brokers offer very restrictive shortGselling margin re/uirements to customers. This means that a customer does not possess the li/uidity to be able to sell stock before he buys it. "argin wise, a trader has e4actly the same

16

capacity when initiating a selling or buying position in the spot market. In spot trading when youBre selling one currency, youBre necessarily buying another. T7+ R)/+ )* F)(+> 43 57+ G/).6/ E1)3)09 1ver time, the foreign e4change market has been an invisible hand that guides the sale of goods, services and raw materials on every corner of the globe. The fore4 market was created by necessity. Traders, bankers, investors, importers and e4porters recogni)ed the benefits of hedging risk, or speculating for profit. The fascination with this market comes from its sheer si)e, comple4ity and almost limitless reach of influence. The market has its own momentum, follows its own imperatives, and arrives at its own conclusions. These conclusions impact the value of all assets Git is crucial for every individual or institutional investor to have an understanding of the foreign e4change markets and the forces behind this ultimate freeGmarket system. InterGbank currency contracts and options, unlike futures contracts, are not traded on e4changes and are not standardi)ed. :anks and dealers act as principles in these markets, negotiating each transaction on an individual basis. (orward HcashH or HspotH trading in currencies is substantially unregulated G there are no limitations on daily price movements or speculative positions.

17

P6(5414:635, I3 F)(+423 E>17632+ M6(=+5,

18

% CUSTOMERS: The customers who are engaged in foreign trade participate in foreign e4change markets by availing of the services of banks. #4porters re/uire converting the dollars into rupee and importers re/uire converting rupee into the dollars as they have to pay in dollars for the goods + services they have imported. Similar types of services may be re/uired for setting any international obligation i.e., payment of technical knowGhow fees or repayment of foreign debt, etc. # COMMERCIAL BANKS They are most active players in the foreign market. Commercial banks dealing with international transactions offer services for conversation of one currency into another. These banks are specialised in international trade and other transactions. They have wide network of branches. -enerally, commercial banks act as intermediary between e4porter and importer who are situated in different countries. Typically banks buy foreign e4change from e4porters and sells foreign e4change to the importers of the goods. Similarly, the banks for e4ecuting the orders of other customers, who are engaged in international transaction, not necessarily on the account of trade alone, buy and sell foreign e4change. %s every time the foreign e4change bought and sold may not be e/ual banks are left with the overbought or oversold position. If a bank buys more foreign e4change than what it sells, it is said to be in Loverbought+plus+long positionM. In case bank sells more foreign e4change than what it buys, it is said to be in Loversold+minus+short positionM. The bank, with open position, in order to avoid risk on account of e4change rate movement, covers its position in the market. If the bank is having oversold position it will buy from the market and if it has overbought position it will sell in the market. This action of bank may

19

trigger a spate of buying and selling of foreign e4change in the market. CENTRAL BANKS In most of the countryMs central bank has been charged with the responsibility of maintaining the e4ternal value of the domestic currency. If the country is following a fi4ed e4change rate system, the central bank has to take necessary steps to maintain the parity, i.e., the rate so fi4ed. #ven under floating e4change rate system, the central bank has to ensure orderliness in the movement of e4change rates. -enerally this is achieved by the intervention of the bank. Sometimes this becomes a concerted effort of central banks of more than one country. '. EXCHANGE BROKERS (oreign market brokers play a very important role in the foreign e4change markets. ?owever the e4tent to which services of fore4 brokers are utili)ed depends on the tradition and practice prevailing at a particular fore4 market centre. In India dealing is done in interbank market through fore4 brokers. In India as per (#.%I guidelines the %.Ms are free to deal directly among themselves without going through brokers. The fore4 brokers are not allowed to deal on their own account all over the world and also in India. G. SPECULATORS Speculators play a very active role in the foreign e4change markets. In fact major chunk of the foreign e4change dealings in foreign markets in on account of speculators and speculative activities. The speculators are the major players in the foreign markets. :anks dealing are the major speculators in the foreign markets with a view to make profit on account of favourable movement in e4change rate, take position i.e., if they feel the rate of particular currency is likely to go up in short term.

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They buy that currency and sell it as soon as they are able to make a /uick profit. THE GOLD STANDARD "any countries have adopted gold standard as their monetary system during the last two decades of the 0=th century. This system was in vogue till the outbreak of world war 0. under this system the parties of currencies were fi4ed in term of gold. There were two main types of gold standardJ -old was recogni)ed as means of international settlement for receipts and payments amongst countries. -old coins were an accepted mode of payment and medium of e4change in domestic market also. % country was stated to be on gold standard if the following condition were satisfiedJ "onetary authority, generally the central bank of the country, guaranteed to buy and sell gold in unrestricted amounts at the fi4ed price. "elting gold including gold coins, and putting it to different uses was freely allowed. Import and e4port of gold was freely allowed. The total money supply in the country was determined by the /uantum of gold available for monetary purpose.

In addition to setting up fi4ed e4change parities A par values C of currencies in relationship to gold, the agreement e4tablished the International "onetary (und AI"(C to act as the custodianN of the system. !nder this system there were uncontrollable capital flows, which lead to major countries suspending their obligation to intervene in the market and the :retton Dood System, with its fi4ed parities, was effectively buried. Thus, the world economy has been living through an era of floating e4change rates since the early 0=>8.

PURCHASING POWER PARITY (PPP!

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,rofessor -ustav 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 e4change rate was to be determined and the sole criterion being the purchasing power of the countries. %s per this theory if there were no trade controls, then the balance of payments e/uilibrium would always be maintained. Thus if 028 I'$ buy a fountain pen and the samen fountain pen can be bought for !S. 3, it can be inferred that since 3 !S. or 028 I'$ can buy the same fountain pen, therefore !S. 3 O I'$ 028. FUNDAMENTALS IN EXCHANGE RATE #4change rate is a rate at which one currency can be e4change in to another currency, say !S. O $s.79. This rate is the rate of conversion of !S dollar in to Indian rupee and vice versa. METHODS FOR QOUTING EXCHANGE RATES
EXCHANGE QUOTATION

.I$#CT P @%$I%:Q# !'IT P ?1"# C!$$#'C;

I'.I$#CT P @%$I%:Q# !'IT P (1$#I-' C!$$#'C;

METODS OF QOUTING RATE There are two methods of /uoting e4change rates. %. D4(+15 0+57)8, (oreign currency is kept constant and home currency is kept variable. In direct /uotation, the principle adopted by bank is to buy at a lower price and sell at higher price. I384(+15 0+57)8-

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?ome currency is kept constant and foreign currency is kept variable. ?ere the strategy used by bank is to buy high and sell low. In India with effect from august 3, 0==6,all the e4change rates are /uoted in direct method. It is customary in foreign e4change 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 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 e4change 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 asM asking party and the party giving a /uotes is known as /uoting party. The advantage of twoRway /uote is as under i. ii. iii. iv. v. The market continuously makes available price for buyers or sellers Two way price limits the profit margin of the /uoting bank and comparison of one /uote with another /uote can be done instantaneously. %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. It automatically insures that alignment of rates with market rates. Two way /uotes lend depth and li/uidity to the market, which is so very essential for efficient market.

S In two way /uotes the first rate is the rate for buying and another for selling. De should understand here that, in India the banks, which are authori)ed dealer, always /uote rates. So the rates /uotedG buying and selling is for banks point of view only. It means that if e4porters 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 buying rate, as the bank is buying the dollars from e4porter. The same case will happen inversely with importer as he will buy dollars from the bank and bank will sell dollars to importer.

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FACTOR AFFECTINGN EXCHANGE RATES In free market, it is the demand and supply of the currency which should determine the e4change rates but demand and supply is the dependent on many factors, which are ultimately the cause of the e4change rate fluctuation, some times wild. The volatility of e4change rates cannot be traced to the single reason and conse/uently, it becomes difficult to precisely define the factors that affect e4change rates. ?owever, the more important among them are as followsJ STRENGTH OF ECONOMY #conomic factors affecting e4change rates include hedging activities, interest rates, inflationary pressures, trade imbalance, and euro market activities. Irving fisher, an %merican economist, developed a theory relating e4change rates to interest rates. This proposition, known as the fisher effect, states that interest rate differentials tend to reflect e4change rate e4pectation. 1n the other hand, the purchasingG power parity theory relates e4change rates to inflationary pressures. In its absolute version, this theory states that the e/uilibrium e4change rate e/uals the ratio of domestic to foreign prices. The relative version of the theory relates changes in the e4change rate to changes in price ratios. POLITICAL FACTOR The political factor influencing e4change rates include the established monetary policy along with government action on items such as the money supply, inflation, ta4es, and deficit financing. %ctive government intervention or manipulation, such as central bank activity in the foreign currency market, also have an impact. 1ther political factors influencing e4change rates include the political stability of a country and its relative economic e4posure Athe perceived need for certain levels and types of importsC. (inally, there is also the influence of the international monetary fund.

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EXPACTATION OF THE FOREIGN EXCHANGE MARKET ,sychological factors also influence e4change rates. These factors include market anticipation, speculative pressures, and future e4pectations. % few financial e4perts are of the opinion that in todayMs environment, the only LtrustworthyM method of predicting e4change rates by gut feel. :ob #veling, vice president of financial markets at S-, is corporate financeMs top foreign e4change forecaster for 0===. #veling gut feeling has, defined convention, and his method proved uncannily accurate in foreign e4change forecasting in 0==9.S- ended the corporate finance forecasting year with a 3.55K error overall, the most accurate among 0= banks. The secret to #veling intuition on any currency is keeping abreast of world events. %ny event, from a declaration of war to a fainting political leader, can take its toll on a currencyMs value. Today, instead of formal modals, most forecasters rely on an amalgam that is part economic fundamentals, part model and part judgment. (iscal policy Interest rates "onetary policy :alance of payment #4change control Central bank intervention Speculation Technical factor

The forward transaction is an agreement between two parties, re/uiring the delivery at some specified future date of a specified amount of foreign currency by one of the parties, against payment in domestic currency by the other party, at the price agreed upon in the contract. The rate of e4change applicable to the forward contract is called the forward exchange rate and the market for forward transactions is known as the forward market.

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The foreign e4change regulations of various countries, generally, regulate the forward e4change transactions with a view to curbing speculation in the foreign e4changes market. In India, for e4ample, commercial banks are permitted to offer forward cover only with respect to genuine e4port and import transactions. (orward e4change facilities, obviously, are of immense help to e4porters and importers as they can cover the risks arising out of e4change rate fluctuations by entering into an appropriate forward e4change contract. F)(<6(8 E>17632+ R65+ Dith reference to its relationship with the spot rate, the forward rate may be at par, discount or premium. A5 P6(: If the forward e4change rate /uoted is e4actly e/uivalent to the spot rate at the time of making the contract, the forward e4change rate is said to be at par. A5 P(+04;0- The forward rate for a currency, say the dollar, is said to be at a premium with respect to the spot rate when one dollar buys more units of another currency, say rupee, in the forward than in the spot market. The premium is usually e4pressed as a percentage deviation from the spot rate on a per annum basis. A5 D4,1);35- The forward rate for a currency, say the dollar, is said to be at discount with respect to the spot rate when one dollar buys fewer rupees in the forward than in the spot market. The discount is also usually e4pressed as a

26

percentage deviation from the spot rate on a per annum basis.

I0:)(5631+ )* F)(<6(8 M6(=+5, The (orward market can be divided into two partsG1utright (orward and Swap market. The 1utright (orward market resembles the Spot market, with the difference that the period of delivery is much greater than 79 hours in the (orward market. % major part of its operations is for clients or enterprises who decide to cover against e4change risks emanating from trade operations. The (orward Swap market comes second in importance to the Spot market and it is growing very fast. The currency swap consists of two separate operations of borrowing and of lending. That is, a Swap deal involves borrowing a sum in one currency for short duration and lending an e/uivalent amount in another currency for the same duration. !S dollar occupies an important place on the Swap market. It is involved in =2 per cent of transactions. "ajor participants in the (orward market are banks, arbitrageurs, speculators, e4change brokers and hedgers. Commercial banks operate on this market through their dealers, either to cover the orders of their clients or to place their own cash in different currencies. %rbitrageurs look for a profit without risk, by operating on the interest rate differences and e4change rates. Speculators take risk in the hope of making a gain in case their anticipation regarding the movement of rates turns out to be correct. %s regards brokers, their job involves match making between seekers and suppliers of currencies on the Spot market. ?edgers are the enterprises or the financial institutions that want to cover themselves against the e4change risk.

27

Q;)5654)3, )3 F)(<6(8 M6(=+5, (orward rates are /uoted for different maturities such as one month, two months, three months, si4 months and one year. !sually, the maturity dates are closer to monthGends. %part from the standardi)ed pattern of maturity periods, banks may /uote different maturity spans, to cater to the market+client needs. The /uotations may be given either in outright manner or through Swap points. 1utright rates indicate complete figures for buying and selling. (or e4ample, Table contains $e+((r /uotations in the outright form. These kinds of rates are /uoted to the clients of banks. If the (orward rate is higher than the Spot rate, the foreign currency is said to be at (orward premium with respect to the domestic currency Ain operational terms, domestic currency is likely to depreciateC. 1n the other hand, if the (orward rate is lower than Spot rate, the foreign currency is said to be at (orward discount with respect to domestic currency Alikely to appreciateC. The difference between the buying and selling rate is called spread and it is indicated in terms of points. The spread on (orward market depends on AaC the currency involved, being higher for the currencies less traded, AbC the volatility of currencies, being wider for the currency with greater volatility and AcC duration of contract, being normally wider for longer period of maturity. Table gives (orward /uotations for different currencies against !S dollar.

28

C)?+(432 E>17632+ R4,= )3 *)(<6(8 M6(=+5 1ften, the enterprises that are e4porting or importing take recourse to covering their operations in the (orward market. If an importer anticipates eventual appreciation of the currency in which imports are denominated, he can buy the foreign currency immediately and hold it up to the date of maturity. This means he has to block his rupee cash right away. %lternatively, the importer can buy the foreign currency forward at a rate known and fi4ed today. This will do away with the problem of blocking of funds+cash initially. In other words, (orward purchase of the currency eliminates the e4change risk of the importer as the debt in foreign currency is covered. Qikewise, an e4porter can eliminate the risk of currency fluctuation by selling his receivables forward. E>60:/+ (rom the data given below calculate forward premium or discount, as the case may be, of the T in relation to the rupee. S)/;54)3 Since 0 month forward rate and 5 months forward rate are higher than the spot rate, the :ritish T is at premium in these two periods, the premium amount is determined separately both for bid price and ask price. It may be recapitulated that the first /uote is the bid price and the second /uote Aafter the slashC is the ask+offer+sell price. It is the normal way of /uotation in foreign e4change markets.

29

I35()8;154)3 Currency (utures were launched in 0=>3 on the International "oney "arket AI""C at Chicago. They were the first financial (utures that developed after coming into e4istence of the floating e4change rate regime. It is to be noted that commodity (utures Acorn, oats, wheat, soybeans, butter, egg and silverC had been in use for a long time. The Chicago :oard of Trade AC:1TC, established in 0=79, speciali)ed in future contract of cereals. The Chicago "ercantile #4change AC"#C started with the future contracts of butter and egg. Qater on, other Currency (uture markets developed at ,hiladelphia A,hiladelphia :oard of TradeC, Qondon AQondon International (inancial (utures #4change AQI((#CC, Tokyo ATokyo International (inancial (utures #4changeC, Sydney ASydney (utures #4changeC, and Singapore International "onetary #4change ASI"#UC. The volume traded on the (utures market is much smaller than that traded on (orward market. ?owever, it holds a very significant position in !S% and !& Aespecially QondonC and it is developing at a fast rate. Dhile a futures contract is similar to a forward contract, there are several differences between them. Dhile a forward contract is tailorGmade for the client by his international bank, a futures contract has standardi)ed features G the contract si)e and maturity dates are standardi)ed. (utures can be traded only on an organi)ed e4change and they are traded competitively. "argins are not re/uired in respect of a forward contract but margins are re/uired of all participants in the futures marketGan initial margin must be deposited into a collateral account to establish a futures position.

30

There are three types of participants on the currency futures marketJ floor traders, floor brokers and brokerGtraders. (loor traders operate for their own accounts. They are the speculators whose time hori)on is shortGterm. Some of them are representatives of banks or financial institutions which use futures to supplement their operations on (orward market. They enable the market to become more li/uid. In contrast, floor brokers, representing the brokersB firms, operate on behalf of their clients and, therefore, are remunerated through commission. The third category, called brokerGtraders, operate either on the behalf of clients or for their own accounts. #nterprises pass through their brokers and generally operate on the (uture markets to cover their currency e4posures. They are referred to as hedgers. They may be either in the business of e4portGimport or they may have entered into the contracts forB borrowing or lending.

C76(615+(4,541, )* C;((+319 F;5;(+, % Currency (uture contract is a commitment to deliver or take delivery of a given amount of currency AsC on a specific future date at a price fi4ed on the date of the contract. Qike a (orward contract, a (uture contract is e4ecuted at a later date. :ut a (uture contract is different from (orward contract in many respects. (utures, being standardi)ed contracts in nature, are traded on an organised e4changeV the clearinghouse of the e4change operates as a link between the two parties of the contract, namely, the buyer and the seller. In other words, transactions are through the clearinghouse and the two parties do not deal directly between themselves.

31

Dhile it is true that futures contracts are similar to the forward contracts in their objective of hedging foreign e4change risk of business firms, they differ in many significant ways. The major differences between the forward contracts and futures contracted are as followsJ N65;(+ 638 ,4H+ )* C)35(615,- (utures contracts are standardi)ed contracts in that dealings in such contracts is permissible in standardGsi)e sums, say multiples of 032,888 -erman .eutschmark or 03.2 million yen. %part from standardGsi)e contracts, maturities are also standardi)ed. In contrast, forward contracts are customi)ed+tailorGmadeV being so, such contracts can virtually be of any si)e or maturity. M)8+ )* T(68432- In the case of forward contracts, there is a direct link between the firm and the authori)ed dealer Anormally a bankC both at the time of entering the contract and at the time of e4ecution. 1n the other hand, the clearinghouse interposes between the two parties involved in futures contracts. L4E;48459- The two positive features of futures contracts, namely their standardG si)e and trading at clearinghouse of an organi)ed e4change, provide them relatively more li/uidity visGIGvis forward contracts, which are neither standardi)ed nor traded through organi)ed futures markets. (or this reason, the future markets are more li/uid than the forward markets. D+:),45,FM6(243,- while futures contracts re/uire guarantee deposits from the parties, no such deposits are needed for forward contracts. :esides, the futures

32

contract necessitates valuation on a daily basis, meaning that gains and losses are noted Athe practice is known as markedGtoGmarketC. @aluation results in one of the parties becoming a gainer and the other a loserV while the loser has to deposit money to cover losses, the winner is entitled to the withdrawal of e4cess margin. Such an e4ercise is conspicuous by its absence in forward contracts as settlement between the parties concerned is made on the preGspecified date of maturity. D+*6;/5 R4,=- %s a se/uel to the deposit and margin re/uirements in the case of futures contracts, default risk is reduced to a marked e4tent in such contracts compared to forward contracts. A15;6/ D+/4?+(9- (orward contracts are normally closed, involving actual delivery of foreign currency in e4change for home currency+or some other country currency Across currency forward contractsC. In contrast, very few futures contracts involve actual deliveryV buyers and sellers normally reverse their positions to close the deal. %lternatively, the two parties simply settle the difference between the contracted price and the actual price with cash on the e4piration date. This implies that the seller cancels a contract by buying another contract and the buyer by selling the contract on the date of settlement. I3 ?4+< )* 57+ 6.)?+I 45 4, 3)5 ,;(:(4,432 5) *438 5765 *)(<6(8 1)35(615, 638 *;5;(+, 1)35(615, 6(+ <48+/9 ;,+8 5+1734E;+, )* 7+82432 (4,=. I5 76, .++3 +,54065+8 5765 0)(+ 5763 "G :+( 1+35 )* 6// 5(63,6154)3, 6(+ 8+,423+8 6, 7+82+,I <457 .63=, 638 *;5;(+, 8+6/+(, ,+(?432 6, 0488/+0+3 .+5<++3 7+82432 C);35+(:6(5. T(68432 P()1+,,

33

Trading is done on trading floor. % party buying or selling future contracts makes an initial deposit of margin amount. If at the time of settlement, the rate moves in its favour, it makes a gain. This amount AgainC can be immediately withdrawn or left in the account. ?owever, in case the closing rate has moved against the party, margin call is made and the amount of BlossB is debited to its account. %s soon as the margin account falls below the maintenance margin, the trading party has to make up the gap so as to bring the margin account again to the original level.

34

INTRODUCTION TO CURRENCY OPTIONS (orward contracts as well as futures contracts provide a hedge to firms against adverse movements in e4change rates. This is the major advantage of such financial instruments. ?owever, at the same time, these contracts deprive firms of a chance to avail the benefits that may accrue due to favorable movements in foreign e4change rates. The reason for this is that the firm is under obligation to buy or sell currencies at perGdetermined rates. This limitation of these contracts, perhaps, is the main reason for the genesis+emergence of currency options in fore4 markets. Currency option is a financial instrument that provides its holder a right but no obligation to buy or sell a preGspecified amount of a currency at a preG determined rate in the future Aon a fi4ed maturity date+up to a certain periodC. Dhile the buyer of an option wants to avoid the risk of adverse changes in e4change rates, the seller of the option is prepared to assume the risk. 1ptions are of two types, namely, call option and put option. C6// O:54)3 In a call option the holder has the right to buy+call a specific currency at a specific price on a specific maturity date or within a specified period of timeV however, the holder of the option is under no obligation to buy the currency. Such an option is to be e4ercised only when the actual price in the fore4 market, at the time of e4ercising option, is more that the price specified in call option contractV to put it differently, the holder of the option obviously will not use the call option in case the actual currency price in the spot market, at the time of using option, turns out to be lower than that specified in the call option contract.

35

P;5 O:54)3 % put option confers the right but no obligation to sell a specified amount of currency at a preGfi4ed price on or up to a specified date. 1bviously, put options will be e4ercised when the actual e4change rate on the date of maturity is lower than the rate specified in the putGoption contract. In view of high potential risk to the sellers of these currency options, option contracts are primarily dealt in the major currencies of the world that are actively traded in the overGtheGcounter A1TCC market. %ll the operations on the 1TC option markets are carried out virtually round the clock. The buyer of the option pays the option price Areferred to as premiumC upfront at the time of entering an option contract with the seller of the option Aknown as the writer of the optionC. E>60:/+ %n Indian importer is re/uired to pay :ritish T 3 million to a !& company in 7 months time. To guard against the possible appreciation of the pound sterling, he buys an option by paying 3 per cent premium on the current prices. The spot rate is $s >>.28+T. The strike price is fi4ed at $s >9.38+T. The Indian importer will need T 3 million in 7 months. In case, the pound sterling appreciates against the rupee, the importer will have to spend a greater amount on buying T 3 million Ain rupeesC. Therefore, he buys a call option for the amount of T 3 million. (or this, he pays the premium upfront, which isJ T 3 million 4 $s >>.28 4 8.83 O $s 6.0 million Then the importer waits for 7 months. 1n the maturity date, his action will depend on the e4change rate of the T visGIGvis the rupee. There are three

36

possibilities in this regard, namely T appreciates, does not change and depreciates. %bove all, there is an additional feature of currency options in that they can be repurchased or sold before the date of maturity Ain the case of %merican type of optionsC. The intrinsic value of an %merican call option is given by the positive difference of spot rate and e4ercise priceV in the case of a #uropean call option, the positive difference of the forward rate and price yields the intrinsic value. Intrinsic value (American option) = Spot rate - price I35(43,41 ?6/;+ (E;():+63 ):54)3! J F)(<6(8 (65+ & :(41+ 1f course, the option e4pires when it is either e4ercised or has attained maturity. 'ormally, it happens when the spot rate+forward rate is lower than the e4ercise priceV otherwise holders of options will normally like to e4ercise their options if they carry positive intrinsic value. Q;)5654)3, )* O:54)3, 1n the 1TC market, premia are /uoted in percentage of the amount of transaction. The payment may take place either in foreign currency or domestic currency. The strike price Ae4ercise priceC is at the choice of the buyer. The premium is composed ofJ A0C Intrinsic @alue, and A3C Time @alue. Thus, we can write the 1ption price as given by the e/uationJ O:54)3 :(41+ J I35(43,41 ?6/;+ K T40+ ?6/;+ 1 INTRINSIC VALU

37

Intrinsic value of an 1ption is e/ual to the gain that the buyer will make on its immediate e4ercise. 1n the maturity, the only value of an 1ption is the intrinsic one. If, on that date, it does not have any intrinsic value, then, it has no value at all.

I35(43,41 ?6/;+ )* C6// O:54)3 Intrinsic value of %merican call 1ption is e/ual to the difference between Spot rate and #4ercise price, because the option can be e4ercised any moment. The e/uation gives the intrinsic value of an %merican call 1ption. I35(43,41 ?6/;+ J S:)5 (65+ & E>+(14,+ :(41+ Qikewise, the intrinsic value of a #uropean call 1ption is given by the e/uationJ I35(43,41 ?6/;+ J F)(<6(8 (65+ & E>+(14,+ :(41+ The intrinsic value of a #uropean 1ption uses (orward rate since it can be e4ercised only on the date of maturity. The intrinsic value of an 1ption is either positive or nil. It is never negative. (or e4ample, the intrinsic value, V, of a #uropean call 1ption whose e4ercise price is $s 73.28 while forward rate is $s 76.88, is going to be @ O $s 76.88 G 73.28 O $s 8.28

38

:ut in case, the (orward rate was $s 73.88, then the intrinsic value of the call 1ption would be )ero.

#. I35(43,41 ?6/;+ P;5 O:54)3 Intrinsic value of a put 1ption is e/ual to the difference between e4ercise price and spot. rate Ain case of %merican 1ptionC and between e4ercise price and (orward rate Ain case of #uropean 1ptionC. (igure graphically presents the intrinsic value of a put 1ption. #/uations give these values.

I35(43,41 ?6/;+ )* A0+(4163 :;5 O:54)3 J E>+(14,+ :(41+ & S:)5 (65+ I35(43,41 ?6/;+ )* E;():+63 :;5 O:54)3 J E>+(14,+ :(41+ & F)(<6(8 (65+ O:54)3,L43&57+ 0)3+9I );5&)*&57+&0)3+9 638 65& 57+&0)3+9 %n 1ption is said to be in-the-money when the underlying e4change rate is superior to the e4ercise price Ain the case of call 1ptionC and inferior to the e4ercise price Ain case of put 1ptionC.

39

Qikewise, it is said to be outGofGtheGmoney when the underlying e4change rate is inferior to the e4ercise price Ain case of call 1ptionC and superior to e4ercise price Ain case of put optionC. Similarly, it is atGtheGmoney when the e4change rate is e/ual to the e4ercise price. F)( +>60:/+, an %merican type call 1ption that enables purchase of !S dollar at the rate of $s 73.28 Ae4ercise priceC while the spot e4change rate on the market is $s 76.88 is inGtheGmoney. If the !S dollar on the spot market is at the rate of $s 73.28, then the call 1ption is atGtheGmoney. (urther, if the !S dollar in the Spot market is at the rate of $s 73.88, it is obviously outGofGtheGmoney. It is evident that an 1ptionGinGtheGmoney will have higher premium than the one outGofGtheGmoney, as it enables to make a profit.

T40+ V6/;+ Time value or e4trinsic value of 1ptions is e/ual to the difference between the price or premium of 1ption and its intrinsic value. #/uation defines this value. Time value o! "ption = #remium - Intrinsic value Suppose a call option enables purchase of a dollar for $s 73.88 while it is /uoted at $s 73.58 in the market, and the premium paid for the call option is $e 0.88, then, Intrinsic value of the option O $s 73.58 G $s 73.88 O $e 8.58

40

Time value of the option O $e 0.88 G A73.58 G 73.88C O $e 8.78 (ollowing factors affect the time value of an 1ptionJ P+(4)8 5765 (+0643, .+*)(+ 57+ 065;(459 865+- %s the 1ption

approaches the date of e4piration, its time value diminishes. This is logical, since the period during which the 1ption is likely to be used is shorter. 1n the date of e4piration, the 1ption has no time value and has only intrinsic value Athat is, premium e/uals intrinsic valueC. D4**+(+3546/ )* 435+(+,5 (65+, )* 1;((+314+, *)( 57+ :+(4)8

1)((+,:)38432 5) 57+ 065;(459 865+ )* 57+ O:54)3- ?igher interest rate of domestic currency means a lower ,@ Apresent valueC of the e4ercise price. So higher interest rate of domestic currency has the same effect as lower e4ercise price. Thus higher domestic interest rate increases the value of a call, making it more attractive and decreases the value of put. 1n the other hand, higher interest rate on foreign currency makes holding of the foreign currency more attractive since the interest income on foreign currency deposit increases. This would have the effect of reducing the value of a call and increasing the value of put. V)/654/459 )* 57+ +>17632+ (65+ )* ;38+(/9432 (*)(+423! 1;((+319-

-reater the volatility greater is the probability of e4ercise of the 1ption and hence higher will be the premium. -reater volatility increases the probability of the spot rate going above e4ercise price for call or going below e4ercise price for put. So price is going to be higher for greater volatility.

41

T9:+ )* O:54)3- %merican 1ption will be typically more valuable than

#uropean 1ption because %merican type gives greater fle4ibility of use whereas the #uropean type is e4ercised only on maturity. F)(<6(8 84,1);35 )( :(+04;0J "ore a currency is likely to decline or

greater is forward discount on it, higher will be the value of put 1ption on it. Qikewise, when a currency is likely to harden Agreater forward premiumC, call on it will have higher value.

S5(65+24+, *)( ;,432 O:54)3,

.ifferent strategies of options may be adopted depending on the anticipations of the market as regards the evolution of e4change rates and volatility. %. ANTICIPATION OF APPRECIATIONS OF UNDERLYING CURRENCY :uying of a call 1ption may result into a net gain if market rate is more than the strike price plus the premium paid. #/uation gives the profit of the buyer of the call 1ption. Call option will be e4ercised only if the e4ercise price is lower than spot price.

,rofit O St G U G c OGc Dhere St O spot rate U O strike price c O premium paid

for St W U for St Y U

X X

42

The profit profile will be e4actly opposite for the seller AwriterC of a call 1ption. -raphically, (igure presents the profits of a call 1ption. #4amples call 1ption strategy.

# ANTICIPATION OF DEPRECIATION OF UNDERLYING CURRENCY :uying of a put 1ption anticipates a decline in the underlying currency. The profit profile of a buyer of put 1ption is given by the e/uation. % put 1ption will be e4ercised only if the e4ercise price is higher than spot rate. ,rofit O U G St G p OGp for U W St X for U Y St X

?ere p representsGthe premium paid for put 1ptions. The opposite is the profit profile for the seller of a put 1ption. -raphically (igure presents the profits of a put 1ption. #4ample illustrates a put 1ption strategy. $ample: S5(65+29 <457 :;5 O:54)3. Spot rate at the time of buying put 1ptionJ < 0.>888+# UO < 0.>028+# p O < 8.85+# The gain+loss for the buyer of put 1ption on e4piry are given in Table (or St W 0.>028, the 1ption will not be e4ercised since ,ound sterling has higher price in the market. There will be net loss of < 8.85. (or 0.5228 Y St Y 0.>028, 1ption will be e4ercised, but there will be net loss. (or St Y 0.5228, the 1ption will be e4ercised and there will be net gain.

43

'. SPREAD Spread refers to the simultaneous buying of an 1ption and selling of another in respect of the same underlying currency. Spreads are often used by traders in banks. % spread is said to be vertical spread or price spread if it is composed of buying and selling of an 1ption of the same type with the same maturity with different strike prices. Spreads are called vertical simply because in newspapers, /uotations of 1ptions for different strike prices are indicated one above the other. They combine the anticipations on the rates and the volatility. 1n the other hand, hori)ontal spread combines simultaneous buying and selling of 1ptions of different maturities with the same strike price. Dhen a call option is bought with a lower strike price and another call is sold with a higher strike price, the ma4imum loss in this combination is e/ual to the difference between the premium earned on selling one option and the premium paid on buying another. This combination is known as bullish call spread. The opposite of this is a bearish call. The other combination is to sell a put 1ption with a higher strike price of U3 and to buy another put 1ption with a lower strike price of U0 "a4imum gain is the difference between the premium obtained for selling and the premium paid for buying. This combination is called bullish put spread while the opposite is bearish put. (igures show the profit profile of bullish spreads using call and put 1ptions respectively. The strategies of spread are used for limited gain and limited loss.

44

C)?+(432 E>17632+ R4,= <457 O:54)3, % currency option enables an enterprise to secure a desired e4change rate while retaining the possibility of benefiting from a favorable evolution of e4change rate. #ffective e4change rate guaranteed through the use of options is a certain minimum rate for e4porters and a certain ma4imum rate for importers. #4change rates can be more profitable in case of their favorable evolution. %part from covering e4change rate risk, 1ptions are also used for speculation on the currency market.

%. C)?+(432 R+1+4?6./+, D+3)04365+8 43 F)(+423 C;((+319 In order to cover receivables, generated from e4ports and denominated in foreign currency, the enterprise may buy put option as illustrated in #4amples $ample: The e4porter @ikrant knows that he would receive !S < 2,88,888 in three months. ?e buys a put option of three months maturity at a strike price of $s 76.88+!S <. Spot rate is $s 76.88+!S <. (orward rate is also $s 76.88+!S <. ,remium to be paid is 3.2 per cent. Show various possibilities of how 1ption is going to be e4ercised. Solution: The e4porter pays the premium immediately, that is, a sum of 8.832 4 < 2,88,888 4 $s 76.88 O $s 26>,288. 'ow let us e4amine different possibilities that may occur at the time of settlement of the receivables.

45

AaC The rate becomes $s 73+!S <. That is, the !S dollar has depreciated. In this situation, put 1ption holder would like to make use of his 1ption and sell his dollars at the strike price, $s 76.88 per dollar. Thus, net receipts would beJ $s 76 4 < 2, 88,888 G $s 76.88 4 8.832 4 < 2,88,888 O $s 76 4 < 2, 88,888 A0 G 8.832C O $s 70.=32 4 2, 88,888 O $s 3, 8=, 53,288 If he had not covered, he would have received $s 73 4 2, 88,888 or $s 30, 88,888. :ut he would not be certain about the actual amount to be received until the date of maturity. AbC .ollar rate becomes $s 76.28. This means that dollar has appreciated a bit. In this case, the e4porter does not stand to gain anything by using his 1ption.

AcC .ollar $ate, on the date of settlement, becomes $s 76.88, that is, e/ual to strike price. In this case also, the e4porter does not gain any advantage by using his option. Thus, the net sum that he gets isJ $s 76.88 4 2, 88, 888 G $s 76 4 8.832 4 2, 88,888 O $s A76 G 76 4 8.832C 4 2, 88,888 O $s 3, 8=, 53,288 It is apparent from the above calculations that irrespective of the evolution of the e4change rate, the minimum amount that he is sure to get is $s 3, 8=, 53,288 and any favourable evolution of e4change rate enables him to reap greater profit.

46

#. C)?+(432 P696./+, D+3)04365+8 43 F)(+423 C;((+319 In order to cover payables denominated in a foreign currency, an enterprise may buy a currency call 1ption. #4amples illustrate the use of call 1ption. $ample %n importer, @ikrant, is to pay one million !S dollars in two months. ?e wants to cover e4change risk with call 1ption. The data are as followsJ Spot rate, forward rate and strike price are $s 76.88 per dollar. The premium is 6 per cent. .iscuss various possibilities that may occur for the importer. Solution: The importer pays the premium amount immediately. That is, a sum of $s 76 4 8.86 4 08, 88,888 or $s 0,3=8,888 is paid as premium. Qet us e4amine the following three possibilities. AaC Spot rate on the date of settlement becomes $s 73.28. That is, there is slight depreciation of !S dollar. In such a situation, the importer does not e4ercise his 1ption and buys !S dollars from the market directly. The net amount that he pays isJ AbC Spot rate, on the settlement date, is $s 76.>2 per !S dollar. #vidently, the !S dollar has appreciated. In this case, the importer e4ercises his 1ption. Thus, the net sum that he pays isJ AcC Spot rate, on the settlement, is the same as the strike price. In such a situation, the importer does not e4ercise 1ption, or ratherV he is indifferent between e4ercise and nonGe4ercise of the 1ption. The net payment that he makes isJ $s76 4 0.86 4 < 08, 88,888

47

Thus, the ma4imum rate paid by the importer is the e4ercise price plus the premium. $ample: %n importer of (rance has imported goods worth !S < 0 million from !S%. ?e wants to cover against the likely appreciation of dollars against #uro. The data are as followsJ S:)5 (65+- E;() $.""$ FUS D S5(4=+ :(41+- E;() $.""FUS D P(+04;0:+( 1+35 M65;(459- 0)357, Dhat are the operations involvedZ

!S dollar appreciates to, say, #uro 0.8608. In this case, the importer e4ercises his call 1ption and thus pays only #uro 08, 0=,>8= as calculated above. !S dollar depreciates to, say, #uro 8.=988. ?ere, the importer abandons the call 1ption and buys !S dollar from the market. ?is net payment is #uro A8.=988 4 08, 88,888 [ 3=,>8=C or #uro 08, 8=,>8=. !S dollar $emains at #uro 8.==. In this case, the importer is indifferent. The sum paid by him is #uro 08, 0=,>8=. The payment profile while using call 1ption is shown in (igure

. C)?+(432 6 B48 *)( 63 O(8+( )* M+(176384,+ %n enterprise that has submitted a tender will like to cover itself against unfavorable movement of currency rates between the time of submission of the

48

bid and its acceptance Ain case it is throughC. If the enterprise does not cover, it runs a risk of s/uee)ing its profit margin, in case foreign currency undergoes depreciation in the meantime. ?owever, if it covers on forward market, and its offer is not accepted, in that eventuality, it will have to sell the currency on the market, perhaps with a loss. Therefore, a better solution in the case of submission of bid for future orders is to cover with put options. The put 1ption enables the enterprise to cover against a decrease in the value of currency on the one hand, and allows him to retain the possibility of benefiting from the increase in the value of the currency on the other. $ample: % company bids for a contract for a sum of 0 million !S dollars. Dhile the period of response is 5 months, the current e4change rate is $s 76.28 per !S dollar. Si4 month forward rate is $s 77.28 per !S dollar. ,remium for a put option of 5 months maturity is 6 per cent with a strike price of $s 76.28. .iscuss various possibilities of losses+gains in case the enterprise decides to cover or not to cover. Solution: AaC If the enterprise does not cover and the dollar rate decreases, the potential loss is unlimited. AbC If the enterprise covers on forward market and if its bid is not accepted and the dollar rate increases, its potential loss is unlimited, since the enterprise will be re/uired to deliver dollars to the bank after buying them at a higher rate. AcC If the enterprise buys a put option, it pays the premium amount of $s 8.86 4 < 08,88,888 4 76.28 or $s 06,82,888. 'ow, there may be two situationsJ

49

0. The bid is accepted and the rate on the date of acceptance is $s 73.88 per dollar, i.e. the !S dollar has depreciated. In this case, the put option is resold Ae4ercisedC with a gain of $s A76.28 G 73.88C 4 < 08, 88,888 or $s 02, 88,888 %fter deducting the premium amount, the net gain works out to be $s 0, =2,888 A$s 02, 88,888 G$s 06, 82,888C. %nd, future receipts are sold on forward market. 1ther possibility is that the bid is accepted but the !S dollar has appreciated to $s 77.88. In that case, the 1ption is abandoned. %nd, the future receipts are sold on forward market. 3. The bid is not accepted and the !S dollar depreciates to $s 73.88. In that case, the enterprise e4ercises its put option and makes a net gain of $s 0, =2,888. In case the bid is not accepted and !S dollar appreciates, the enterprise simply abandons its 1ption and its loss is e/ual to the premium amount paid. R+6,)3, *)( C;((+319 S<6: C)35(615, % swap contract makes it possible at a lower cost. Some of the significant reasons for entering into swap contracts are given below. Swapping one currency liability with another is a way of eliminating e4change rate risk. (or e4ample, if a company Ain !&C e4pects certain inflows of deutschemarks, it can swap a sterling liability into deutschemark liability. %. D4**+(432 F4363146/ N)(0, The norms for judging creditGworthiness of companies differ from country t5 country. (or e4ample, -ermany or Eapanese companies may have much higher debtGe/uity ratios than what may be acceptable to !S lenders. %s a result, a -erman or Eapanese company may find it difficult to raise a dollar loan in !S%. It would be much easier and cheaper for these companies to raise a home currency loan and then swap it with a dollar loan.

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#.C(+845 R65432 Certain countries such as !S% attach greater importance to credit rating than some others like those in continental #urope. The latter look, inter-alia, at companyBs reputation and other important aspects. :ecause of this difference in perception about rating, a well reputed company like I:" evenGwith lower rating may be able to raise loan in #urope at a lower cost than in !S%. Then this loan can be swapped for a dollar loan. . M6(=+5 S65;(654)3 If an organisation has borrowed a si)able sum in a particular currency, it may find it difficult to raise additional loans due to BsaturationB of its borrowing in that currency. The best way to tide over this difficulty is to borrow in some other BunsaturatedB currency and then swap. % wellGknown e4ample of this kind of swap is Dorld :ankGI:" swap. ?aving borrowed heavily in -erman and Swiss market, the D: had difficulty raising more funds in -erman and Swiss currencies. The problem was resolved by the D: making a dollar bond issue and swapping it with I:"Bs e4isting liabilities in deutschemark and Swiss franc. E>60:/+-& Suppose Company :, a :ritish firm, had issued T 50 million poundG denominated bonds in the !& to fund an investment in (rance. %lmost at the same time, Company (, a (rench firm, has issued T 28 million of (rench francG denominated bonds in (rance to make the investment in !&. 1bviously, Company : earns in (rench franc A(fC but is re/uired to make payments in the :ritish pound. Qikewise, Company ( earns in pound but is to make payments in (rench francs. %s a result, both the companies are e4posed to foreign e4change risk.

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(oreign e4change risk e4posure is eliminated for both the companies if they swap payment obligations. Company : pays in pound and Company ( pays in (rench francs. Qike interest rate swaps, e4tra payment may be involved from one company to another, depending on the creditworthiness of the companies. It may be noted that the eventual risk of nonGpayment of bonds lies with the company that has initially issued the bonds. This apart, there may be differences in the interest rates attached to these bonds, re/uiring compensation from one company to another.

0. ,arties involve e4change debt obligations in different currencies, 3. #ach party agrees to pay the interest obligation of the other party and 6. 1n maturity, principal amounts are e4changed at an e4change rate agreed in advance.

The majority of Indian corporates have at least 98K of their foreign e4change transactions in !S .ollars. This is wholly unacceptable from the point of view of prudent $isk "anagement. H.onBt put all your eggs in one basketH is the essence of $isk .iversification, one of the cornerstones of prudent $isk "anagement. #ven if a Corporate does not have a direct e4posure to any currency other than the !S., it can use (orward Contracts or 1ptions to create the desired e4posure profile. Thankfully, this is permitted by the $:I. This is not Speculation. It is prudent, informed and proactive $isk "anagement.

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%s seen, the bad news is that .ollarG$upee volatility has increased. The good news is that forecasts can put you ahead of the market and ahead of the competition. If you look at the chart below you will observe, .ollarG$upee volatility has increased from 2 paise per day in 3887 to about 38 paise per day today. It is set to increase further, to 62G72 paise per day over the ne4t 03 months. 'ow the /uestion here is, how do you protect your business from (ore4 volatilityZ Eust need to track the "arket every moment and by any dealerMs forecasts. They help keep you on the right side of the market. They have an enviable track record Alook at the chart on the right hand topC to back up profits from high volatile market. Take the services of many (UGdealers that include longGterm forecasts, daily updates as well as hedging advice for the corporates.

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CHAPTER

S;22+,54)3, 638 F438432,-&

%. D)3M5 (+68 57+ 3+<, L636/9H+ 57+ 3+<,. "any times straightforward news releases from government agencies are really public relation vehicles to advance a particular point of view or policy. Such news,N in the fore4 markets more than any other, is used as a tool to affect the investment psychology of the crowd. Such media manipulation is not inherently a negative. -overnments and traders try to do that all the time. The new fore4 trader must reali)e that it is important to read the news to assess the message behind the drums. (or e4ample, EapanMs ,rime "inister "asajuro Shiokowa was /uoted in a news report on .ec. 06 that an e4cessive depreciation of the yen should be avoided. :ut we should make efforts and give consideration to guide the yen lower if it is relatively overvalued.N Dhen a government official is asking, in effect, if traders would please slow down the weakening of his currency, then we must wonder whether there is fear the opposite will happen. In this case, that was the outcome as on .ec. 07 the dollar vs. the yen surged to a threeGyear high. #! D)3M5 5(68+ 17632+-& % price surge is a signature of panic or surprise. In these events, professional traders take cover and see what happens. The retail trader also should let the market digest such shocks. Trading during an announcement or right before, or amid some turmoil, minimi)es the odds of predicting the probable direction. Technical indicators during surge periods will be distorted. ;ou should wait for a confirmation of the new direction and remember that price action will tend to revert to preGsurge ranges providing nothing
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fundamental has occurred.:ut within a short period of time, the surge that reflected the tendency to panic retraced.

! S40:/+ 4, .+55+(. The desire to achieve great gains in fore4 trading can drive us to keep adding indicators in a neverGending /uest for the impossible dream. Similarly, trading with a do)en indicators is not necessary. "any indicators just add redundant information. Indicators should be used that give clues toJ $esistance, Support and

:uying and selling pressure.

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CONCLUSION

(oreign e4change market plays a vital role in integrating the global economy. It is a 37Ghour in over the counter market Rmade up of many different types of players each with it set of rules, practice & disciplines. 'evertheless the market operates on professional bases & this professionalism is held together by the integrity of the players. The Indian foreign e4change market is no e4pectation to this international market re/uirement. Dith the liberali)ation, privati)ation & globali)ation initiated in India. Indian foreign e4change markets have been reasonably liberated to play there efficiently. ?owever much more need to be done to make over market vibrant, deep in li/uid. .erivative instrument are very useful in managing risk. :y themselves, they do not have any value nut when added to the underline e4posure, they provide e4cellent hedging mechanism. Some of the popular derivate instruments are forward contract, option contract, swap, future contract & forward rate agreement. ?owever, they have to be handle very carefully otherwise they may throw open more risk then in originally envisaged.

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BIBLIOGRAPHY

'ews ,apers 0. .'% "oney, 3. :usiness Standard & 6. :usiness line

:11&S 0. International finance by ,.-.%,T# 3. "anagement of (oreign #4change by :I"%Q E%i%' 6. (oreign #4change "arkets by ,.&. Eain 7. #G:11&S on Trading Strategies in (ore4 "arket.

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