Financial Management Assignment

Managing Currency Risk

Prepared By,
Rahul Pareek
IMI, New Delhi

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Acknowledgement

We would like to express our gratitude to all those who gave us the

possibility to complete this report.

We are deeply indebted to our Professor Dr. N L Ahuja whose help,

stimulating suggestions and encouragement helped us in carrying out the

assignment. His continuous support in the program was always motivating

for us. He was always there to listen and to give advice to us. He showed

different ways to approach a problem and the need to be persistent to

accomplish any goal.

Further we are thankful to the Executive (Anonymous) of R Systems

International for extending his full fledged support and allowing us to use

the confidential information of their organisation.

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Table of Contents
Foreign Exchange Risks 4
Translation Exposure 6
Transaction Exposure 8
Other Risk 9
Derivative and other Instruments 11
Spot Exchange Market 12
Forward Exchange Market 14
Currency Future 15

Currency Options 17

Exotic Options 22

Currency Swaps 26

Interest Rate Swap 29

Indian Foreign Exchange Market 31

Currency Risk Management 51

Hedging used by Companies 56

Infosys technologies ltd 57

HCL Technologies Ltd 60
Gokaldas Exports ltd 61

Tata Consultancy Services 63

R Systems International Ltd. 64

Comparative Analysis 66

Interview with Manager 68

Conclusion 71

Bibliography 72

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Foreign Exchange Risks

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Foreign Exchange Risk

Foreign exchange risk is the possibility of a gain or loss to a firm that occurs due to unanticipated
changes in exchange rate. It is linked to unexpected fluctuations in the value of currencies. A
strong currency can very well be risky, while a weak currency may not be risky. The risk level
depends on whether the fluctuations can be predicted. Short and long- term fluctuations have a
direct impact on the profitability and competitiveness of business.

The high volatility of exchange rates is a fact of life faced by any company engaged in
international business. For example, if an Indian firm imports goods and pays in foreign currency
(say dollars), its outflow is in dollars, thus it is exposed to foreign exchange risk. If the value of
the foreign currency rises (i.e., the dollar appreciates), the Indian firm has to pay more domestic
currency to get the required amount of foreign currency.

Typically, a Foreign exchange risks, therefore, pose one of the greatest challenges to a
multinational companies. These risks arise because multinational corporations operate in
multiple currencies. Infact, many times firms who have a diversified portfolio find that the
negative effect of exchange rate changes on one currency are offset by gains in others i.e. -
exchange risk is diversifiable.

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Types of Exposure

Translation Exposure

It is the degree to which a firm’s foreign currency denominated financial statements are affected
by exchange rate changes. All financial statements of a foreign subsidiary have to be translated
into the home currency for the purpose of finalizing the accounts for any given period. If a firm
has subsidiaries in many countries, the fluctuations in exchange

rate will make the assets valuation different in different periods. The changes in asset valuation
due to fluctuations in exchange rate will affect the group’s asset, capital structure ratios,
profitability ratios, solvency rations, etc.

The Company records the gain or loss on effective hedges in the foreign currency fluctuation
reserve until the transactions are complete. On completion, the gain or loss is transferred to the
profit and loss account of that period.

The following procedure has been followed:

• Assets and liabilities are to be translated at the current rate that is the rate prevailing at the
time of preparation of consolidated statements.

• All revenues and expenses are to be translated at the actual exchange rates prevailing on the
date of transactions. For items occurring numerous times weighted averages for exchange rates
can be used.

• Translation adjustments (gains or losses) are not to be charged to the net income of the
reporting company. Instead these adjustments are accumulated and reported in a separate
account shown in the shareholders equity section of the balance sheet, where they remain until
the equity is disposed off.

Measurement of Translation exposure

Translation exposure = (Exposed assets - Exposed liabilities) (change in the exchange rate)

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Example

Current exchange rate $1 = Rs 47.10

Assets Liabilities Assets Liabilities

Rs. 15,300,000 Rs. 15,300,000

$ 3,24,841 $ 3,24,841

In the next period, the exchange rate fluctuate§ to $1 = Rs 47.50

Assets Liabilities Assets Liabilities

Rs. 15,300,000 Rs. 15,300,000

$ 3,22,105 $ 3,22,105

Decrease in Book Value of the assets is $ 2736

The various steps involved in measuring translation exposure are:

First, Determine functional currency.

Second, Translate using temporal method recording gains/ losses in the income statement as
realized.

Third, Translate using current method recording’ gains/losses in the balance sheet and as
realized.

Finally, consolidate into parent company financial statements.

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Transaction Exposure

This exposure refers to the extent to which the future value of firm’s domestic cash flow is
affected by exchange rate fluctuations. It arises from the possibility of incurring foreign

exchange gains or losses on transaction already entered into and denominated in a foreign
currency.

The degree of transaction exposure depends on the extent to which a firm’s transactions are in
foreign currency: For example, the transaction in exposure will be more if the firm has more
transactions in foreign currency. Unlike translation gains and loses which

require only a bookkeeping adjustment, transaction gains and losses are realized as soon as
exchange rate changes. The exposure could be interpreted either from the standpoint

of the affiliate or the parent company. An entity cannot have an exposure in the currency in
which its transactions are measured.

Transaction risk is associated with the change in the exchange rate between the time an
enterprise initiates a transaction and settles it. For Example, an exporter may quote a price of $
10,000 based on exchange rate of Rs. 30 per dollar. He hopes to receive Rs. 3,80,000 on
executing the order. If the contract is executed after three months, and the exchange rate is at
Rs. 34 per dollar, the exporter receives only Rs. 3,40,000 short of his expectations by Rs. 40,000.
It is this uncertainty about the amount to be received on conversion that leads to transaction
exposure. The Transaction losses or gain absorbed in the profit and loss account for the year
concerned , and thus affect the profit of the enterprise.

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Economic Exposure

Economic exposure refers to the degree to which a firm’s present value of future cash flows can
be influenced by exchange rate fluctuations. Economic exposure is a more managerial concept
than an accounting concept. A company can have an economic exposure to say Pound/Rupee
rates even if it does not have any transaction or translation exposure in the British currency. This
situation would arise when the company’s competitors are using British imports. If the Pound
weakens, the company loses its competitiveness (or vice versa if the Pound becomes
strong).Thus, economic exposure to an exchange rate is the risk that a variation in the rate will
affect the company’s competitive position in the market and hence its profits. Further, economic
exposure affects the profitability of the company over a longer time span than transaction or
translation exposure. Under the Indian exchange control, economic exposure cannot be hedged
while both transaction and translation exposure can be hedged.

Credit Risk

This type of risk includes the likelihood that a counter party may fail to repay an outstanding
currency position on purpose or unintentionally. There are several types of credit risk, such as:

Replacement risk - results when the counterparties who should pay the refunds are not able to
pay their due.

Settlement risk - caused by geographic differences in time. As a result the trading of a currency
may occur at different price at different times during one and the same trading day.

Country Risk

This type of risk is related to governments that participate in foreign exchange market by
interfering in t

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Derivatives and Other Instrument

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Introduction
The foreign exchange (currency, forex or FX) market is where currency trading takes place. FX
transactions typically involve one party purchasing a quantity of one currency in exchange for
paying a quantity of another. The FX market is one of the largest and most liquid financial
markets in the world, and includes trading between large banks, central banks, currency
speculators, corporations, governments, and other institutions. The average daily volume in the
global forex and related markets is continuously growing. Traditional turnover was reported to
be over US$ 3.2 trillion in April 2007 by the Bank for International Settlement. Since then, the
market has continued to grow. According to Euromoney's annual FX Poll, volumes grew a
further 41% between 2007 and 2008.

This approximately $3.21 trillion in main foreign exchange market turnover was broken down as
follows:

 $1.005 trillion in spot transactions

 $362 billion in outright forwards
 $1.714 trillion in forex swaps
 $129 billion estimated gaps in reporting

TOP CURRENCY TRADERS AS ON MAY 2008

Rank Name Volume

1 Deutsche Bank 21.7%
2 UBS AG 15.8%
3 Barclays Capital 9.12%
4 Citi 7.49%
5 Royal Bank of Scotland 7.30%
6 JPMorgan 4.19%
7 HSBC 4.1%

Spot Exchange Market

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Spot transactions in the foreign exchange market are increasing in volume. This trade represents
a “direct exchange” between two currencies, has the shortest time frame, involves cash rather
than a contract; and interest is not included in the agreed-upon transaction. It is estimated that
about 90 percent of spot transactions are done exclusively for banks. The rest are for covering
the orders of the clients of banks, which are essentially enterprise. The exchange of currency
takes place within 48 hours and it works round the clock. According to BIS estimate, the daily
volume of spot exchange transactions is about 50 percent of the total transactions of exchange
markets. Major participants on the spot market are commercial banks, dealers, brokers,
arbitrageurs, speculators and central banks.

The exchange rate is the price of one currency expressed in another currency. There is always
one rate for buying (bid rate) and another for selling (ask of offered rate) for a currency. The bid
rate is the rate at which the quoting bank is ready to buy a currency. Selling rate is the rate at
which it is ready to sell a currency. For Example, if dollar is quoted as Rs 50.0012-50.0030, it
means that the bank is ready to buy dollar (bid rate) at Rs 50.0012 and ready to sell dollar at Rs
50.0030. The positive difference between selling and buying constitutes the profit made by the
bank. There are two types of quotes:

 Direct quote : It takes the value of foreign currency as 1 unit. India uses this type of
quote. $1=Rs 50.
 Indirect quote : It takes the value of home currency as 1 unit. UK , Ireland & South Africa
are some of the example. In UK, £1= Rs70.

The difference between the bid price and the ask price is called a spread. If we were to look at
the following quote: EUR/USD = 1.2500/03, the spread would be 0.0003 or 3 pips, also known as
points. The pip is the smallest amount a price can move in any currency quote. In the case of the
U.S. dollar, euro, British pound or Swiss franc, one pip would be 0.0001. With the Japanese yen,
one pip would be 0.01, because this currency is quoted to two decimal places. So, in a forex
quote of USD/CHF, the pip would be 0.0001 Swiss francs. Most currencies trade within a range
of 100 to 150 pips a day.

When a currency quote is given without the U.S. dollar as one of its components, this is called a
cross currency. The most common cross currency pairs are the EUR/GBP, EUR/CHF and EUR/JPY.
These currency pairs expand the trading possibilities in the forex market, but it is important to

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note that they do not have as much of a following (for example, not as actively traded) as pairs
that include the U.S. dollar, which also are called the majors.

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Forward Exchange Market

Unlike the spot market, the forwards markets do not trade actual currencies. Instead they deal
in contracts that represent claims to a certain currency type, a specific price per unit and a
future date for settlement. In the forwards market, are bought and sold OTC between two
parties, who determine the terms of the agreement between themselves. The forward market
can be divided into two parts:

 Outright Market : It resembles the spot market, with the difference that the period of
delivery is much greater than 48 hours. A major part of its operations is for client and
enterprise who decide to cover against exchange risks coming from trade operations.
 Forward Swap Market : It consists of two separate operations of borrowing and of
lending.

Major participants in the forward market are banks, arbitrageurs, speculators, exchange brokers
and hedgers. Hedgers are the financial institution who want to cover themselves against the
exchange risk.

Forward rates are quoted for different maturities such as one year, six month, three month. If
the forward rate is higher than the spot rate, the foreign currency is said to be in forward
premium with respect to the domestic currency. Otherwise it is called forward discount.
Mathematically,

Forward Rate−Spot Rate 12

Premium∨Discount= × ×100
Spot Rate N
Where N is the number of months forward.

Covering Exchange risk on foreign market The enterprises that are exporting or importing take
to covering their operations in the forward market. If an importer anticipates eventual
appreciation of the currency in which the imports are taken, he can buy the foreign currency
and hold it up till maturity. Alternatively, the importer can buy the foreign currency forward at a
rate known and fixed today. This eliminates the exchange risk of the importer as the debt in
foreign currency is covered. Like wise an exporter can eliminate the risk of currency fluctuation
by selling his receivables forward.

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Currency Futures

Currency future, also FX future or foreign exchange future, is a futures contract to exchange one
currency for another at a specified date in the future at a price (exchange rate) that is fixed on
the purchase date. There are three types of participants on the currency futures market : floor
traders, floor brokers and broker- traders. A currency future contract is a commitment to deliver
or take delivery of a given amount of currency on a specific future date at a price fixed on the
date of the contract. The major distinguishing features from forward are:

1. Standardisation
2. Organised exchanges
3. Minimum Variation
4. Clearing House
5. Margins
6. Marking to Market

Covering Risk on currency futures market In this a long position is covered by a short position
on futures market and vice versa. In order to have a perfect cover, it is necessary cover that the
value of the spot and future move by the same amount but in opposite directions. But, not often
the variation is one to one and the cover is perfect. There is risk for the basis.

This risk, however, is very small in comparison to the risk incurred due to the uncovered
position. On futures market, the basic principle of operating is that two parties that anticipate
opposite movements of rates agree to a exchange a certain amount of currencies on a future
date at an agreed price. If the anticipation about the future turns out to be correct, he would
have made a gain by compensating on the loss made on the spot market. Both parties, after
entering into the contract, are obliged to respond to the calls of clearing house for margin
payments.

For example, Ram is a Indian-based investor who will receive $1,000,000 on December 1. The
current exchange rate implied by the futures is Rs50/$. He can lock in this exchange rate by
selling $1,000,000 worth of futures contracts expiring on December 1. That way, she is
guaranteed an exchange rate of Rs50/$ regardless of exchange rate fluctuations in the
meantime.

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The future and spot rate are linked by the equation :

D
1+ Intrest rate of home currency ×
360
Future Rate=Spot Rate ×
D
1+ Intrest rate of foreigncurrency ×
360

Where D is number of days to maturity.

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Currency Options

It is a derivative financial instrument where the owner has the right but not the obligation to
exchange money denominated in one currency into another currency at a pre-agreed exchange
rate on a specified date. Options are traded over the counter(OTC) as well as on organised
market. In terms of volume of transactions, USA, UK and Japan are on top.

When the right to use an option is exercised on a fixed date, the option is said to be a European
option. On the other hand, when the right to use an option can be exercised at any time during
the life of the option, up to the date of maturity, referred as American Option.

There are two types of options :

 Call Option : The buyer of the option has the right, but not the obligation to buy an agreed
quantity of a particular commodity or financial instrument (the underlying instrument) from
the seller of the option at a certain time (the expiration date) for a certain price (the strike
price). The seller (or "writer") is obligated to sell the commodity or financial instrument
should the buyer so decide. The buyer pays a fee (called a premium) for this right. The buyer
of a call option wants the price of the underlying instrument to rise in the future; the seller
either expects that it will not, or is willing to give up some of the upside (profit) from a price
rise in return for the premium (paid immediately) and retaining the opportunity to make a
gain up to the strike price (see below for examples).Call options are most profitable for the
buyer when the underlying instrument is moving up, making the price of the underlying
instrument closer to the strike price. When the price of the underlying instrument surpasses
the strike price, the option is said to be "in the money".

 Put Option : The put allows its buyer the right but not the obligation to sell a commodity or
financial instrument (the underlying instrument) to the writer (seller) of the option at a
certain time for a certain price (the strike price). The writer (seller) has the obligation to
purchase the underlying asset at that strike price, if the buyer exercises the option. The put
buyer either believes it's likely the price of the underlying asset will fall by the exercise date,
or hopes to protect a long position in the asset. The advantage of buying a put over shorting

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 the asset is that the risk is limited to the premium. The put writer does not believe the price
of the underlying security is likely to fall. The writer sells the put to collect the premium.

The premium is composed of two values:

 Intrinsic Value
For Call Option
Intrinsic Value = Spot Rate – Exercise price (American Call option)
Intrinsic Value = Forward Rate – Exercise price (European Call option)

For Put Option

Intrinsic Value = Exercise price – Spot Rate (American Call option)
Intrinsic Value = Exercise price – Forward Rate (European Call option)
Options
 In-the-money : When the underlying exchange rate is superior to the exercise
price(in case of call) and inferior to the exercise price(in case of put option).
 Out-of-money : When the underlying exchange rate is inferior to the exercise
price(in case of call) and superior to the exercise price(in case of put option).
 At-the-money : When the exchange rate is equal to the exercise price.

Example, an American type Call option that enables purchase of US Dollar at the rate of Rs
50.50(exercise price) while the spot exchange rate on the market is Rs 51 is in-the-money. If the
rate is Rs 50.50 then it is at-the-money and if the rate is Rs 50 then it is out-of-money.

 Time Value
Time Value of Option = Premium – Intrinsic Value

Option Price = Intrinsic value + Time value

Strategy for using options

An option strategy is implemented by combining one or more option positions and possibly an
underlying stock position. Options strategies can favour movements in the underlying stock that
are bullish, bearish or neutral.

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Bullish Strategies

Bullish options strategies are employed when the options trader expects the underlying stock
price to move upwards. It is necessary to assess how high the stock price can go and the time
frame in which the rally will occur in order to select the optimum trading strategy. The most
bullish of options trading strategies is the simple call buying strategy used by most novice
options traders.

Buying of a call option may result into a net gain if market rate is more than the strike price plus
the premium paid. Call option will be exercised only if the exercise price is lower than spot price.

Profit = St – X – c for St > X

= -c for St < X

Where St = spot price

X = strike price

c = premium paid

Bearish Strategies

Bearish options strategies are the mirror image of bullish strategies. They are employed when
the options trader expects the underlying stock price to move downwards. It is necessary to
assess how low the stock price can go and the time frame in which the decline will happen in
order to select the optimum trading strategy. The most bearish of options trading strategies is
the simple put buying strategy.

Buying of a put option may result into a net gain if market rate plus the premium paid is less
than the strike price.

Profit = X - St – p for St < X

=–p for St > X

Where

St = spot price X = strike price p = premium paid

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Neutral or Non-Directional Strategies

Neutral strategies in options trading are employed when the options trader does not know
whether the underlying stock price will rise or fall. Also known as non-directional strategies,
they are so named because the potential to profit does not depend on whether the underlying
stock price will go upwards or downwards. Rather, the correct neutral strategy to employ
depends on the expected volatility of the underlying stock price.

Examples of neutral strategies are:

1. Straddle: A Straddle strategy involves holding a position in both a call and put with the
same strike price and expiration. The position is profitable (to the buyer) if the
underlying stock changes value in a significant way, either higher or lower. The premium
paid is the sum of the premium paid for each of them.

Profit = X - St – ( p + c ) for St < X (I)

Profit = St – X – ( p + c ) for St < X (II)

The equation (I) is the combination of the use of put option and non use of call option
whereas the equation (II) is the combination of use of call option and non use of put
option.

2. Strangle: It is similar to straddle but with a difference. It is the combination of buying a

call with strike price above the current spot rate, and put with strike price below the
current spot rate. Gains are made for larger movement of the currency and moderate
losses for moderate movement.

3. Butterfly: Long butterfly spread means buying two calls with middle strike price (X 2) and
selling each with lower (X1) and higher (X3) strike price respectively. Similarly, a short
butterfly involves selling two calls with middle strike price (X 2) and buying each with
lower (X1) and higher (X3) strike price respectively.

4. Spread: It refers to the simultaneous buying of an option and selling of another in

respect of the same underlying currency. A spread is said to be vertical spread if it is
composed of buying and selling of an option of the same type with the same maturity

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 with different strike prices. Horizontal spread combines simultaneous buying and selling
of options of different maturities with the same strike price.

Covering Exchange Risk With Options  Effective exchange rate guaranteed through the use of
options is a certain minimum rate for exporters and a certain maximum rate for importers.
Exchange rates can be more profitable in case of their favourable evolution.

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Exotic Options

We have already talked about so-called "plain vanilla options", the simple puts and calls that are
priced in the exchange-traded markets and the over-the-counter markets for equities, fixed
income, foreign exchange and commodities. Exotic options are either variations on the payoff
profiles of the plain vanilla options or they are wholly different kinds of products with optionally
embedded in them. An exotic option is a derivative which has features making it more complex
than commonly traded products (vanilla options). These products are usually traded over-the-
counter (OTC), or are embedded in structured notes.

Barrier Options

A barrier option is like a plain vanilla option but with one exception: the presence of one or two
trigger prices. If the trigger price is touched at any time before maturity, it causes an option with
pre-determined characteristics to come into existence (in the case of a knock-in option) or it will
cause an existing option to cease to exist (in the case of a knock-out option).

There are single barrier options and double barrier options. A double barrier option has barriers
on either side of the strike (i.e. one trigger price is greater than the strike and the other trigger
price is less than the strike). A single barrier option has one barrier that may be either greater
than or less than the strike price. Why would we ever buy an option with a barrier on it?
Because it is cheaper than buying the plain vanilla option and we have a specific view about the
path that spot will take over the lifetime of the structure.

Intuitively, barrier options should be cheaper than their plain vanilla counterparts because they
risk either not being knocked in or being knocked out. A double knockout option is cheaper than
a single knockout option because the double knockout has two trigger prices either of which
could knock the option out of existence. How much cheaper a barrier option is compared to the
plain vanilla option depends on the location of the trigger.

First, let us think of the case where the barrier is out-of-the-money with respect to the strike.
Consider the example of a plain vanilla 1.55 US dollar Call/Canadian dollar put that gives the
holder the right to buy USD against Canadian dollars at a rate of 1.55 for 1 month's maturity.
Spot is currently trading at 1.54. Consider now the 1.55 US dollar call/Canadian dollar put

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expiring in 1 month that has a knockout trigger at 1.50. The knockout option will be cheaper
than the plain vanilla option because it might get knocked out and the holder of the option
should be compensated for this risk with a lower up front premium. However, it is not very likely
that 1.50 will trade, so the difference in price is not that great. If we move the trigger to 1.53,
the knockout option becomes considerably cheaper than the plain vanilla option because 1.53 is
much more likely to trade in the next month.

The reverse logic applies to knock-in options. The knock-in 1 month 1.55 US dollar call with a
trigger of 1.53 will be more expensive than the 1 month 1.55 US dollar call with a knock-in
trigger of 1.50 because 1.53 is more likely to trade. If we own the 1 month 1.55 US dollar
call/Canadian dollar put that knocks out at 1.53 and we also own the 1 month 1.55 US dollar
call/Canadian dollar put that knocks in at 1.53, the combined position is equivalent to owning
the plain vanilla 1 month 1.55 US dollar call.

Compound Options

A compound option is an option-on-an-option. It could be a call-on-a-call giving the owner the

right to buy in 1 month's time a 6 month 1.55 US dollar call/Canadian dollar put expiring 7
months from today (or 6 months from the expiry of the compound). The strike price on the
compound is the premium that we would pay in 1 month's time if we exercised the compound
for the option expiring 6 months from that point in time. It could be a put-on-a-call giving the
owner the right to sell in 1 month's time a 6 month 1.55 US dollar call/Canadian dollar put
expiring 7 months from today.

These types of products are often used by corporations to hedge the foreign exchange risk
involved with overseas acquisitions when the success of the acquisition itself is uncertain.

Basket Options

A basket option is an option whose payoff is linked to a portfolio or "basket" of underlier values.
The basket can be any weighted sum of underlier values so long as the weights are all positive.
Basket options are usually cash settled. A call option on France's CAC 40 stock index is an
example of a basket option.

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Basket options are popular for hedging foreign exchange risk. A corporation with multiple
currency exposures can hedge the combined exposure less expensively by purchasing a basket
option than by purchasing options on each currency individually.

Basket options are often priced by treating the basket's value as a single underlier and applying
standard option pricing formulas. An error is introduced by the fact that a weighted sum of
lognormal random variables in not lognormal, but this is generally modest.

Lookback Options

A lookback option is a path dependent option settles based upon the maximum or minimum
underlier value achieved during the entire life of the option. Essentially, at expiration, the holder
can "look back" over the life of the option and exercise based upon the optimal underlier value
achieved during that period. Lookback can be structured as puts or calls and come in two basic
forms:

 A fixed strike lookback option is cash settled and has a strike set in advance. It is exercised
based upon the optimal underlier value achieved during the life of the option. In the case of
a call, this is the highest underlier value achieved, so the call has a payoff equal to the
greater of: zero or the difference between that highest value and the fixed strike. In the case
of a put, the optimal value is the lowest underlier value achieved, and the payoff is the
greater of: zero or the difference between the strike and that lowest value.

 A floating strike lookback option can have cash or physical settled. It settles based upon a
strike that is set equal to the optimal value achieved by the underlier over the life of the
option. In the case of a call, that optimal value is the lowest value achieved by the underlier,
so the call has a payoff equal to the difference between the value of the underlier at
expiration and the lowest value achieved by the underlier over the life of the option. In the
case of a put, the payoff is the difference between the highest value achieved by the
underlier and the value of the underlier at expiration.

Lookback options have obvious appeal, but they are expensive. Their structure doesn't mimic
typical business liabilities, so they are largely a speculative device.

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Quanto Options

A quanto (or cross-currency derivative) is a cash settled derivative (such as a future or option)
that has an underlier denominated in one ("foreign") currency, but settles in another
("domestic") currency at a fixed exchange rate. For example, the Chicago Mercantile Exchange
(CME) trades futures on Japan's Nikkei 225 stock index that settles for USD 5.00 for each JPY .01
of value in the Nikkei index. If you hold a future, and the Nikkei rises JPY 12 (or 12 points), you
earn USD 6000.

Quantos are attractive because they shield the purchaser from exchange rate fluctuations. If a
US investor were to invest directly in the Japanese stocks that comprise the Nikkei, he would be
exposed to both fluctuations in the Nikkei index and fluctuations in the USD/JPY exchange rate.
Essentially, a quanto has an embedded currency forward with a variable notional amount. It is
those variable notional amounts that give quantos their name—"quanto" is short for "quantity
adjusting option."

Quanto options have both the strike price and underlier denominated in the foreign currency. At
exercise, the value of the option is calculated as the option's intrinsic value in the foreign
currency, which is then converted to the domestic currency at the fixed exchange rate.

EXOTIC OPTIONS - DIFFERENCE BETWEEN EXOTIC OPTIONS & STANDARD OPTIONS

Exotic Options Plain Vanilla Options

Customised Standardized

OTC Traded Publicly Traded

Many Types Single Type

More Expensive Cheaper

No Standard Pricing Standardized Pricing Model

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Currency Swaps

A currency swap (or cross currency swap) is a foreign exchange agreement between two parties
to exchange a given amount of one currency for another and, after a specified period of time, to
give back the original amounts swapped. Initial loan was given at the spot rate, reimbursement
of principle as well as interest took into account forward rate.

Typical currency swaps involves three steps;

1. Initial exchange of principal amount: In the first step, the counterparties exchange the
principal amounts of the swap at an agreed exchange rate. This rate is generally based on
the spot exchange rate however, a forward rate set in advance of the swap commencement
date may also be used. The principal amounts may be exchanged on physical or notional,
without any physical change, basis.

2. Exchange of interest: It is the second key step for a currency swap. The counterparties
exchange interest payments on agreed dates based on outstanding principal amounts at the
fixed interest rates agreed at the beginning of transaction.

3. Re-exchange of principal maturity: This step involves re-exchange of the principal sum at
the maturity date by the counterparts. In order to determine the actual sums involved
generally the original spot rate is used.

Participants in swap markets are

 Financial Institutions: It enables them to make loans and accept deposits in the currency of
their customer’s choice. It can involve as broker, counterparty or an intermediary.

 Big enterprises: They are mostly multinationals. They may also be big and medium
enterprises with good ratings such as SNCF and EDF.

 International organisations: Institutions like World Bank and nation states.

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 SWAPPING A USD LOAN INTO AN AUD LOAN

By entering into a swap with a third party, a corporation can convert an USD loan into an
AUD loan.
Currency swaps can be divided into three categories :

 Fixed-to-fixed currency swap: An arrangement between two parties (known as

counterparties) in which both parties pay a fixed interest rate that they could not otherwise
obtain outside of a swap arrangement.

US Company UK Company
US Dollar 5% 7%
Sterling 7.5% 8%
Comparative Advantage $-2% & £-0.5%
Take a loan $ 10 million from 5.0% £ 15 million from 8.0%
Exchange Rate £ = $1.50 £ = $1.50
Principle Exchange £ 15 million from 7% $ 10 million from 6.5%
Interest Paid 7.0% for £ loan 6.5% for $ loan
Interest received 5.0% for $ loan 8.0% for £ loan
Coupon Payment 5.0% for $ loan 8.0% for £ loan
Net Interest Paid 7% 6.5%
Interest gains 0.5% 0.5%

The above table shows that a US company is able to borrow from low fixed rates in US bond
market. On the other side, a UK company is also able to raise low fixed rates funds from UK

27 | P a g e
bond market. In case of both the companies wish to raise funds denominated by other country’s
currency, first, each will borrow from its own domestic market by using the comparative
advantage. Second, via fixed-to-fixed swap each will be able to raise lower cost of their funds in
terms of foreign currency. However, the case is such that the US company’s credibility is better
in each market, the swap transaction would be as it is shown in the above Table.

The table illustrates that the US Company has a comparative advantage in both bond markets,
but it will also prefer swap. Because by sharing the gain among the parties, the US Company and
the UK Company, each of them may raise funds with lower costs and saves 0.5% each.
Therefore, each company borrows from the domestic markets and exchanges the principals
from the rate of 7.0% for sterling and 6.5% for US dollar. During the life of swap UK and US
companies will service each other’s debt.

 Fixed-to-Floating rate currency swap : It follows the same sequence of steps as do fixed-to-
fixed rate swaps, with the difference that one currency has fixes rate while the other has
floating rate. While the fixed rate is charged over the entire period of the swap, the floating
rate is re-calculated every six months. Thus, if the UK company can raise capital at a fixed
rate on UK market but prefers to obtain dollars at floating rate, it have to find borrowers
who is highly rated on American market and who can borrow on that market on floating rate
with better conditions but who like to borrow sterling’s at fixed rate.

 Floating-to-Floating rate currency swap : In this both the currency has floating rate. It
enables both parties to draw benefit from the difference of interest rates existing on
segmented markets.

Hedging Exchange Risk  Swapping one currency liability with another is a way of eliminating
exchange rate risk. For example, if a company (in India) expects certain inflows of dollars, it can
swap a Rupee liability into dollar liability.

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Interest Rate Swap

An agreement between two parties (known as counterparties) where one stream of future
interest payments is exchanged for another based on a specified principal amount. Interest rate
swaps often exchange a fixed payment for a floating payment that is linked to an interest rate
(most often the LIBOR). A company will typically use interest rate swaps to limit, or manage, its
exposure to fluctuations in interest rates, or to obtain a marginally lower interest rate than it
would have been able to get without the swap. Interest rate swaps are simply the exchange of
one set of cash flows (based on interest rate specifications) for another. Because they trade
OTC, they are really just contracts set up between two or more parties, and thus can be
customized in any number of ways. With an interest rate swap, cash flows occurring on
concurrent dates are netted.

Generally speaking, swaps are sought by firms that desire a type of interest rate structure that
another firm can provide less expensively. For example, let's say Cory's Tequila Company (CTC) is
seeking to loan funds at a fixed interest rate, but Tom's Sports Inc. (TSI) has access to marginally
cheaper fixed-rate funds. Tom's Sports can issue debt to investors at its low fixed rate and then
trade the fixed-rate cash flow obligations to CTC for floating-rate obligations issued by TSI. Even
though TSI may have a higher floating rate than CTC, by swapping the interest structures they
are best able to obtain inexpensively, the combined costs are decreased - a benefit that can be
shared by both parties.

Vanilla currency swaps are quoted

both for fixed-floating and floating-floating (basis swap) structures. Fixed-floating swaps are
quoted with the interest rate payable on the fixed side—just like a vanilla interest rate swap.
The rate can either be expressed as an absolute rate or a spread over some government bond
rate. The floating rate is always "flat"—no spread is applied. Floating-floating structures are
quoted with a spread applied to one of the floating indexes.

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Indian Money Market

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Indian Foreign Exchange Market
The evolution of India’s foreign exchange market may be viewed in line with the shifts in India’s
exchange rate policies over the last few decades from a par value system to a basket-peg and
further to a managed float exchange rate system. During the period from 1947 to 1971, India
followed the par value system of exchange rate. Initially the rupee’s external par value was fixed
at 4.15 grains of fine gold. The Reserve Bank maintained the par value of the rupee within the
permitted margin of ±1 per cent using pound sterling as the intervention currency. Since the
sterling-dollar exchange rate was kept stable by the US monetary authority, the exchange rates
of rupee in terms of gold as well as the dollar and other currencies were indirectly kept stable.
The devaluation of rupee in September 1949 and June 1966 in terms of gold resulted in the
reduction of the par value of rupee in terms of gold to 2.88 and 1.83 grains of fine gold,
respectively. The exchange rate of the rupee remained unchanged between 1966 and 1971.

With the breakdown of the Bretton Woods System in 1971 and the floatation of major
currencies, the conduct of exchange rate policy posed a serious challenge to all central banks
world wide as currency fluctuations opened up tremendous opportunities for market players to
trade in currencies in a borderless market. In December 1971, the rupee was linked with pound
sterling. Since sterling was fixed in terms of US dollar under the Smithsonian Agreement of 1971,
the rupee also remained stable against dollar. In order to overcome the weaknesses associated
with a single currency peg and to ensure stability of the exchange rate, the rupee, with effect
from September 1975, was pegged to a basket of currencies. The currency selection and weights
assigned were left to the discretion of the Reserve Bank. The currencies included in the basket
as well as their relative weights were kept confidential in order to discourage speculation. It was
around this time that banks in India became interested in trading in foreign exchange.

The impetus to trading in the foreign exchange market in India came in 1978 when banks in
India were allowed by the Reserve Bank to undertake intra-day trading in foreign exchange and
were required to comply with the stipulation of maintaining ‘square’ or ‘near square’ position
only at the close of business hours each day. The extent of position which could be left
uncovered overnight (the open position) as well as the limits up to which dealers could trade

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during the day were to be decided by the management of banks. The exchange rate of the rupee
during this period was officially determined by the Reserve Bank in terms of a weighted basket
of currencies of India’s major trading partners and the exchange rate regime was characterised
by daily announcement by the Reserve Bank of its buying and selling rates to the Authorised
Dealers (ADs) for undertaking merchant transactions. The spread between the buying and the
selling rates was 0.5 per cent and the market began to trade actively within this range. ADs were
also permitted to trade in cross currencies (one convertible foreign currency versus another).
However, no ‘position’ in this regard could originate in overseas markets.

The post reform phase (1992 onwards) was marked by wide ranging reform measures aimed at
widening and deepening the foreign exchange market and liberalisation of exchange control
regimes. A credible macroeconomic, structural and stabilization programme encompassing
trade, industry, foreign investment, exchange rate, public finance and the financial sector was
put in place creating an environment conducive for the expansion of trade and investment. It
was recognised that trade policies, exchange rate policies and industrial policies should form
part of an integrated policy framework to improve the overall productivity, competitiveness and
efficiency of the economic system, in general, and the external sector, in particular.

As a stabilsation measure, a two step downward exchange rate adjustment by 9 per cent and 11
per cent between July 1 and 3, 1991 was resorted to counter the massive drawdown in the
foreign exchange reserves, to instill confidence among investors and to improve domestic
competitiveness. A two-step adjustment of exchange rate in July 1991 effectively brought to
close the regime of a pegged exchange rate.

The dual exchange rate system was replaced by a unified exchange rate system in March 1993,
whereby all foreign exchange receipts could be converted at market determined exchange rates.
On unification of the exchange rates, the nominal exchange rate of the rupee against both the
US dollar as also against a basket of currencies got adjusted lower, which almost nullified the
impact of the previous inflation differential. The restrictions on a number of other current
account transactions were relaxed. The unification of the exchange rate of the Indian rupee was
an important step towards current account convertibility, which was finally achieved in August
1994.

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With the rupee becoming fully convertible on all current account transactions, the risk-bearing
capacity of banks increased and foreign exchange trading volumes started rising. This was
supplemented by wide-ranging reforms undertaken by the Reserve Bank in conjunction with the
Government to remove market distortions and deepen the foreign exchange market. The
process has been marked by gradualism’ with measures being undertaken after extensive
consultations with experts and market participants. The reform phase began with the Sodhani
Committee (1994) which in its report submitted in 1995 made several recommendations to relax
the regulations with a view to vitalising the foreign exchange market

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Measures Initiated to Develop the Foreign Exchange Market in India

Institutional Framework
• The Foreign Exchange Regulation Act (FERA), 1973 was replaced by the market friendly Foreign
exchange Management Act (FEMA), 1999. The Reserve Bank delegated powers to authorised
dealers (ADs) to release foreign exchange for a variety of purposes.
• In pursuance of the Sodhani Committee’s recommendations, the Clearing Corporation of India
Limited (CCIL) was set up in 2001.
• To further the participatory process in a more holistic manner by taking into account all
segments of the financial markets, the ambit of the Technical Advisory Committee (TAC) on
Money and Securities Markets set up by the Reserve Bank in 1999 was expanded in 2004 to
include foreign exchange markets and the Committee was rechristened as TAC on Money,
Government Securities and Foreign Exchange Markets.

Increase in Instruments in the Foreign Exchange Market

• The rupee-foreign currency swap market was allowed.

• Additional hedging instruments such as foreign currency-rupee options, cross-currency
options, interest rate swaps (IRS) and currency swaps, caps/ collars and forward rate
agreements (FRAs) were introduced.

Liberalisation Measures

• Authorised dealers were permitted to initiate trading positions, borrow and invest in overseas
market, subject to certain specifications and ratification by respective banks’ Boards. Banks
were also permitted to (i) fix net overnight position limits and gap limits (with the Reserve Bank
formally approving the limits); (ii) determine the interest rates (subject to a ceiling) and maturity
period of FCNR(B) deposits with exemption of inter-bank borrowings from statutory
preemptions; and (iii) use derivative products for asset liability management.

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• Participants in the foreign exchange market, including exporters, Indians investing abroad, and
FIIs were permitted to avail forward cover and enter into swap transactions without any limit,
subject to genuine underlying exposure.
• FIIs and NRIs were permitted to trade in exchange traded derivative contracts, subject to
certain conditions.
• Foreign exchange earners were permitted to maintain foreign currency accounts. Residents
were permitted to open such accounts within the general limit of US $ 25,000 per year, which
was raised to US $ 50,000 per year in 2006, has further increased to US $ 1,00,000 since April
2007.

Disclosure and Transparency Initiatives

The Reserve Bank has been taking initiatives in putting in public domain all data relating to
foreign exchange market transactions and operations. The Reserve Bank disseminates: (a) daily
reference rate which is an indicative rate for market observers through its website, (b) data on
exchange rates of rupee against some major currencies and foreign exchange reserves on a
weekly basis in the Weekly Statistical Supplement (WSS), and (c) data on purchases and sales of
foreign currency by the Reserve Bank in its Monthly Bulletin. The Reserve Bank has already
achieved full disclosure of information pertaining to international reserves and foreign currency
liquidity position under the Special Data Dissemination Standards (SDDS) of the IMF.

(Reference: Mohan, Rakesh. 2006. “Financial Sector Reforms and Monetary Policy: The Indian
Experience.” RBI Bulletin, July.)

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Market Players

Players in the Indian market include (a) ADs, mostly banks who are authorised to deal in foreign
exchange, (b) foreign exchange brokers who act as intermediaries, and (c) customers –
individuals, corporates, who need foreign exchange for their transactions. Though customers
are major players in the foreign exchange market, for all practical purposes they depend upon
ADs and brokers. In the spot foreign exchange market, foreign exchange transactions were
earlier dominated by brokers. Nevertheless, the situation has changed with the evolving market
conditions, as now the transactions are dominated by ADs. Brokers continue to dominate the
derivatives market. The Reserve Bank intervenes in the market essentially to ensure orderly
market conditions. The Reserve Bank undertakes sales/purchases of foreign currency in periods
of excess demand/supply in the market. Foreign Exchange Dealers’ Association of India (FEDAI)
plays a special role in the foreign exchange market for ensuring smooth and speedy growth of
the foreign exchange market in all its aspects. All ADs are required to become members of the
FEDAI and execute an undertaking to the effect that they would abide by the terms and
conditions stipulated by the FEDAI for transacting foreign exchange business. The FEDAI is also
the accrediting authority for the foreign exchange brokers in the interbank foreign exchange
market.

The licenses for ADs are issued to banks and other institutions, on their request, under Section
10(1) of the Foreign Exchange Management Act, 1999. ADs have been divided into different
categories. All scheduled commercial banks, which include public sector banks, private sector
banks and foreign banks operating in India, belong to category I of ADs. All upgraded full fledged
money changers (FFMCs) and select regional rural banks (RRBs) and co-operative banks belong
to category II of ADs. Select financial institutions such as EXIM Bank belong to category III of
ADs. Currently, there are 86 (Category I) Ads operating in India out of which five are co-
operative banks (Table 6.3). All merchant transactions in the foreign exchange market have to
be necessarily undertaken directly through ADs. However, to provide depth and liquidity to the
inter-bank segment, Ads have been permitted to utilise the services of brokers for better price
discovery in their inter-bank transactions. In order to further increase the size of the foreign
exchange market and enable it to handle large flows, it is generally felt that more ADs should be

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encouraged to participate in the market making. The number of participants who can give two-
way quotes also needs to be increased.

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Derivative Market Instruments

Derivatives play a crucial role in developing the foreign exchange market as they enable market
players to hedge against underlying exposures and shape the overall risk profile of participants
in the market. Banks in India have been increasingly using derivatives for managing risks and
have also been offering these products to corporates. In India, various informal forms of
derivatives contracts have existed for a long time though the formal introduction of a variety of
instruments in the foreign exchange derivatives market started only in the post-reform period,
especially since the mid-1990s. Cross-currency derivatives with the rupee as one leg were
introduced with some restrictions in April 1997. Rupee-foreign exchange options were allowed
in July 2003. The foreign exchange derivative products that are now available in Indian financial
markets can be grouped into three broad segments, viz., forwards, options (foreign currency
rupee options and cross currency options) and currency swaps (foreign currency rupee swaps
and cross currency swaps)

38 | P a g e
Foreign Exchange Derivative Instruments in India

Foreign Exchange Forwards

Authorised Dealers (ADs) (Category-I) are permitted to issue forward contracts to persons
resident in India with crystallised foreign currency/foreign interest rate exposure and based on
past performance/actual import-export turnover, as permitted by the Reserve Bank and to
persons resident outside India with genuine currency exposure to the rupee, as permitted by the
Reserve Bank. The residents in India generally hedge crystallised foreign currency/ foreign
interest rate exposure or transform exposure from one currency to another permitted currency.
Residents outside India enter into such contracts to hedge or transform permitted foreign
currency exposure to the rupee, as permitted by the Reserve Bank.

Foreign Currency Rupee Swap

A person resident in India who has a long-term foreign currency or rupee liability is permitted to
enter into such a swap transaction with ADs (Category-I) to hedge or transform exposure in
foreign currency/foreign interest rate to rupee/rupee interest rate.

Foreign Currency Rupee Options

ADs (Category-I) approved by the Reserve Bank and Ads (Category-I) who are not market makers
are allowed to sell foreign currency rupee options to their customers on a back-to-back basis,
provided they have a capital to risk weighted assets ratio (CRAR) of 9 per cent or above. These
options are used by customers who have genuine foreign currency exposures, as permitted by
the Reserve Bank and by ADs (Category-I) for the purpose of hedging trading books and balance
sheet exposures.

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Cross-Currency Options

ADs (Category-I) are permitted to issue cross-currency options to a person resident in India with
crystallised foreign currency exposure, as permitted by the Reserve Bank. The clients use this
instrument to hedge or transform foreign currency exposure arising out of current account
transactions. ADs use this instrument to cover the risks arising out of market-making in foreign
currency rupee options as well as cross currency options, as permitted by the Reserve Bank.

Cross-Currency Swaps

Entities with borrowings in foreign currency under external commercial borrowing (ECB) are
permitted to use cross currency swaps for transformation of and/or hedging foreign currency
and interest rate risks. Use of this product in a structured product not conforming to the specific
purposes is not permitted.

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Derivatives Market: Comprehensive Guidelines

The draft comprehensive guidelines issued on December 11, 2006 cover broad generic principles
for undertaking derivative transactions, permissible categories of derivative instruments,
defining the role of market makers and users, suitability and appropriateness policies, risk
management and corporate governance aspects, and internal control and audit. Subsequently, a
modified version of these guidelines incorporating the comments of a wide spectrum of banks
and market participants was issued by the Reserve Bank on April 20, 2007. These guidelines for
accounting and valuation of derivatives, already circulated, are expected to provide a holistic
framework for regulating the derivatives business of banks in future. Comprehensive guidelines
contain four main modifications in the existing guidelines pertaining to instruments in foreign
exchange derivatives. First, users such as importers and exporters having crystallised unhedged
exposure in respect of current account transactions may write covered call and put options in
both foreign currency/rupee and cross currency and receive premia. Second, market makers
may write cross currency options. Third, market makers may offer plain vanilla American foreign
currency rupee options. Fourthly, a person resident in India having foreign exchange or rupee
liability is permitted to enter into a foreign currency rupee swap for hedging long-term
exposure, i.e., exposure with residual maturity of three years or more.

For risk management and corporate governance related to banks’ exposure to derivatives
markets, basic principles of a prudent system have been specified in the comprehensive
guidelines. These basic principles mainly entail (i) appropriate oversight by the board of
directors and senior management; (ii) adequate risk management process that integrates
prudent risk limits, sound measurement procedures and information systems, continuous risk
monitoring and frequent management reporting; and (iii) comprehensive internal controls and
audit procedures.

Regarding risk management, the guidelines explain identification and accurate measurement of
various types of risks, by the market makers, involved in derivative activities. Accurate
measurement of derivative related risks is necessary for proper monitoring and control and,
therefore, all significant risks should be measured and integrated into an entity-wide risk

41 | P a g e
management system. The guidelines further elucidate various risk limits, viz., market risk limits,
credit limits, and liquidity limits, which serve as a means to control exposures to various risks
associated with derivative activities. Apart from above mentioned principles, the guidelines also
include the requirement of a mechanism for an independent monitoring of each entity and
controlling of various risks in derivatives. Furthermore, the guidelines cover details pertaining to
internal audit, prudential norms relating to derivatives, prudential limits on derivatives, and
regulatory reporting and balance sheet disclosures.

(Reference: Reserve Bank of India, 2006. Comprehensive Guidelines on Derivatives Market.)

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Foreign Exchange Market Trading Platform

A variety of trading platforms are used by dealers in the EMEs for communicating and trading
with one another on a bilateral basis. They conduct bilateral trades through telephones that are
later confirmed by fax or telex. Some dealers also trade on electronic trading platforms that
allow for bilateral conversations and dealing such as the Reuters Dealing 2000-1 and Dealing
3000 Spot systems. Bilateral conversations may also take place over networks provided by
central banks and over private sector networks (Brazil, Chile, Colombia, Korea and the
Philippines). Reuters’ Dealing System has been the most popular trading platform in EMEs.

In the Indian foreign exchange market, spot trading takes place on four platforms, viz., FX CLEAR
of the CCIL set up in August 2003, FX Direct that is a foreign exchange trading platform launched
by IBS Forex (P) Ltd. in 2002 in collaboration with Financial Technologies (India) Ltd., and two
other platforms by the Reuters - D2 platform and the Reuters Market Data System (RMDS)
trading platform that have a minimum trading amount limit of US $ 1 million. FXCLEAR and FX
Direct offer both real time order matching and negotiation modes for dealing. The Real Time
Matching system enables real time matching of currency pairs for immediate and auto
execution in both the spot and forward segments. In the Negotiated Dealing System, on the
other hand, participant is free to choose and negotiate with his counter-party on all aspects of
the transaction, thereby offering him flexibility to select the underlying currency as well as the
terms of trade. These trading platforms cover the US dollar-Indian Rupee (USDINR) transactions
and transactions in major cross currencies (EUR/USD, USD/JPY, GBP/USD etc.), though USD-INR
constitutes the most of the foreign exchange transactions in terms of value. It is the FX CLEAR of
the CCIL that remains the most widely used trading platform in India. This platform has been
given to members free of cost. The main advantage of this platform is its offer of straight-
through processing (STP) capabilities as it is linked to CCIL’s settlement platform.

In the forward segment of the Indian foreign exchange market, trading takes place both over the
counter (OTC) and in an exchange traded market with brokers playing an important role. The
trading platforms available include FX CLEAR of the CCIL, RMDS from Reuters and FX Direct of
the IBS.

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In order to enhance the efficiency and transparency of the foreign exchange market and make it
comparable with the markets of other EMEs, the Committee on Fuller Capital Account
Convertibility (FCAC, 2006) has proposed the introduction of an electronic trading platform for
the conduct of all foreign exchange transactions. Under such an arrangement, an authorised
dealer will fix certain limits for its clients for trading in foreign exchange, based on a credit
assessment of each client or deposit funds or designated securities as collateral. A number of
small foreign exchange brokers could also be given access to the foreign exchange trading
screen by the authorised dealers. In the case of electronic transaction, the buy/sell order for
foreign exchange of an authorised dealer’s client first flows from the client’s terminal to that of
the authorised dealers’ dealing system. If the client’s order is within the exposure limit, the
dealing system will automatically route the order to the central matching system. After the
order gets matched, the relevant details of the matched order would be routed to the client’s
terminal through the trading system of the authorised dealer. Such a system would also have
the advantage of the customer having the choice of trading with the bank quoting the best price
and the Reserve Bank’s intervention in the foreign exchange market could remain anonymous.
For very large trades, a screen negotiated deal system has been proposed by the Committee on
Fuller Capital Account Convertibility.

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Foreign Exchange Market Turnove

The Indian foreign exchange market has grown manifold over the last several years. The daily
average turnover impressed a substantial pick up from about US $ 5 billion during 1997-98 to US
$ 18 billion during 2005-06. The turnover has risen considerably to US $ 23 billion during 2006-
07 (up to February 2007) with the daily turnover crossing US $ 35 billion on certain days during
October and November 2006. The inter-bank to merchant turnover ratio has halved from 5.2
during 1997-98 to 2.6 during 2005-06

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47 | P a g e
Summary

The Indian foreign exchange market has operated in a liberalised environment for more than a
decade. A cautious and well-calibrated approach was followed while liberalising the foreign
exchange market with an emphasis on the need to safeguard against potential financial
instability that could arise due to excessive speculation. The focus was on gradually dismantling
controls and providing an enabling environment to all entities engaged in external transactions.
The approach to liberalisation adopted by the Reserve Bank has been characterised by greater
transparency, data monitoring and information dissemination and to move away from micro
management of foreign exchange transactions to macro management of foreign exchange
flows. The emphasis has been to ensure that procedural formalities are minimised so that
individuals are able to conduct hassle free current account transactions and exporters and other
users of the market are able to concentrate on their core activities rather than engage in
avoidable paper work. With a view to maintaining the integrity of the market, strong know your-
customer (KYC)/anti-money laundering (AML) guidelines have also been put in place.

Banks have been given significant autonomy to undertake foreign exchange operations. In order
to deepen the foreign exchange market, several products have been introduced and new
players have been allowed to enter the market. Full convertibility on the current account and
extensive liberalisation of the capital account has resulted in large increase in transactions in
foreign currency. These have also enabled the corporates to hedge various types of risks
associated with foreign currency transactions. The impact of these reform initiatives is clearly
discernible in terms of depth and efficiency of the market.

Exchange rate regimes do influence the regulatory framework when it comes to the issue of
providing operational freedom to market participants in respect of their foreign exchange
market operations. Notwithstanding a move towards greater exchange rate flexibility by most
EMEs, almost all central banks in EMEs actively participate in their foreign exchange markets to
maintain orderly conditions. While the use of risk management instruments is encouraged by
many emerging markets for hedging genuine exposures linked to real and financial flows, their
overall approach towards risk management has remained cautious with an emphasis on the

48 | P a g e
need to safeguard against potential financial instability arising due to excessive speculation in
the foreign exchange market.

In the coming years, the challenge for the Reserve Bank would be to further build up on the
strength of the foreign exchange market and carry forward the reform initiatives, while
simultaneously ensuring that orderly conditions prevail in the foreign exchange market. Besides,
with the Indian economy moving towards further capital account liberalisation, the
development of a well-integrated foreign exchange market also becomes important as it is
through this market that cross-border financial inflows and outflows are channelled to other
markets. Development of the foreign exchange market also needs to be co-ordinated with the
capital account liberalisation. Reforms in the financial markets is a dynamic process and need to
be harmonised with the evolving macroeconomic developments and the level of maturity of
participating financial institutions and other segments of the financial market.

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Risk Management

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Currency Risk Management
In managing currency risk, multinational firms utilize different hedging strategies depending on
the specific type of currency risk. These strategies have become increasingly complicated as they
try to address simultaneously transaction, translation and economic risks. As these risks could
be detrimental to the profitability and the market valuation of a firm, corporate treasurers, even
of smaller-size firms, have become increasingly proactive in controlling these risks. Thereby, a
greater demand for hedging protection against these risks has emerged and, in response, a
greater variety of instruments has been generated by the ingenuity of the financial engineering
industry.

Companies can successfully manage currency risk by following five steps:

Risk Definition

Risk Definition refers to the type of risk to be measured. A company engaged in currency risk
has basically four types of exposure :-

 Transaction Exposure
 Translation Exposure
 Forecasted Exposure
 Economic Exposure

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Each exposure effects company in different way as explained below

Measurement Methodology

Measuring and managing exchange rate risk exposure is important for reducing a firm’s
vulnerabilities from major exchange rate movements, which could adversely affect profit
margins and the value of assets. After defining the types of exchange rate risk that a firm is
exposed to, a crucial aspect of a firm’s exchange rate risk management decisions is the
measurement of these risks. Measurement Methodology create a model to measure the
currency exposure to be managed. Measuring currency risk may prove difficult, at least with
regards to translation and economic risk.

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Some of the methodology usually employed by corporate are :-

Exposure Gathering Techniques

After methodology has been defined by the company, next step is to gather data and calculate
exposure of currency risk. The process can be best described as below :-

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Covering Strategy

Once exposure has been calculated , the companies need to decide on covering strategies which
will determine to what extent and how exposure will be measured. Various Covering strategies
are :-

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Hedge Execution

Once companies identifies exposure and decide to hedge it , there are series of ways by which
hedge exposure is carried through trade execution and other techniques. The flow of the
process is as following :-

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Hedging Strategy used by
Companies

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Infosys Technologies Ltd.

Infosys revenue in dollar terms grew by 35% in 2008, while it grew just by 19% in INR (functional
currency of Infosys). Infosys notionally lost around Rs. 2000 crores in revenue and Rs. 1000
crores in net profit.

Infosys received 98.4% of its revenues from export, making it very much vulnerable to
fluctuations in foreign exchange rates. The table below list the revenues from different
geographies.

Geography Percentage Share in Revenues

North America 63.1%
Europe 26.9%
Rest of World 8.6%

Composition of Currency Wise Revenue

Currency 2008 2007

US Dollar 70.7 73.7
UK Pound 14.1 11.6
Euro 5.7 4.9
Australian Dollar 4.6 4.9

Infosys hedges its foreign currency risk in different currencies as different currencies do not
appreciate/depreciate similarly. For ex while US Dollar appreciated 11.2% against INR, U.K
Pound appreciated only 6.4% and Euro appreciated just 1.8%

Infosys uses forwards and options (including exotic options) to hedge its currency risk. Infosys
outstanding options & forward contracts as on 31 March 2008 are as following:

In millions $ In Crores In millions In Crores

Forward contract 521 2085 10 63
option contract
Range barrier 100 400
Euro accelerator 12 76

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 Euro forward 5 32
Total 621 2485 27 171

Effectiveness of hedging Strategies of Infosys

(figures in crores) 2008 2007 2006

Transaction & Translation losses INR (98) INR (21) INR (8)
Option/ Forward Contracts - gains/(losses) INR 103 INR 63 INR (69)
Net INR 5 INR 42 INR (77)

Trends in hedged exposure of currencies

On the basis of Annual Revenue

(Figures in Crores) 2008 2007 2006

Income 15648 13149 9028
Hedged Exposure 2656 1928 1418
% hedged 16.97% 14.66% 15.71%

Infosys hedges around 15-17% of its annual revenue at any point of time

On basis of Debtors or Collection on basis of DSO (Days Sales Outstanding)

2008 2007 2006

Debtors 3093 2292 1518
Hedged Exposure 2656 1928 1418
% hedged 85.87% 84.12% 93.41%

Period in days 2008 2007 2006

0-30 58.3 58.5 61.1
31-60 29.1 36.7 31.3
61-90 3.9 2.1 3.2
91+ 8.7 2.7 4.4
Revenues Due in 2 months 87.4 95.2 92.4

Infosys hedges around 85-90% of debtors or around 2 months receivables

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Trends in hedging strategies

2008 % 2007 % 2006 %

Forward contract 2148 81% 723 40% 445 32%
Option contract
Range Barrier 400 15% 884 49% 934 67%
Euro accelerator 76 3% 138 8% 16 1%
Euro forward 32 1% 47 3%
Total 2656 1792 1395

We can observe change in hedging strategy of Infosys with shift towards using forwards contract
and using less of Options, specially decline in use of Range Barrier

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HCL Technologies Ltd.

HCL hedges its currency risk by taking forwards in 3 different currencies namely Swedish Krona,
US Dollar & Japanese Yen.

Following is the outstanding contracts of HCL as on 30 th June 2007 & 2008

(Figures in Crores INR) 2008 2007

USD 341.7 228.6
SEK 9.2 8.5
JPY 5.0 4.6
355.9 241.7

Revenue & Debtors of HCL at the end of financial year

2008 2007
Sales 12489 11721
Debtors 1248 1005

Hypothesis on basis of Days Sales Outstanding (DSO)

HCL days of sales is 36 days, So HCL hedged 10 days of sales exposure in 2008 and 9 days of sales
revenue in 2007

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Gokaldas Exports Ltd.

Gokaldas uses only forward contracts to hedge against its foreign currency exposure. It receives
93% of its revenue from foreign exchange earnings. The geographical segmentation of its
revenue is as follows

Geography % Share
USA & Canada 52
Europe 37
Other Countries 5
India 6

Income & Debtors at the end of financial year 2007 & 2008

(Figures in Crores) INR 2008 2007

Revenue 1092 1039
Debtors 866 798
94% of the debtors are receivables within 6 months in 2008 & 97% of debtors were receivable
within 6 months in 2007

Following is the outstanding foreign exchange exposure

(Figures in
Crores) 2008 2007
Dollar Euro Dollar Euro
Sell Contract INR 255.26 INR 157.52 INR 100.32 INR -
buy Contract INR 2.39 INR - INR - INR -
Net INR 410.39 INR 100.32

Hypothesis on the basis of debtors

Debtors receivable within 6

months 814.04 774.06
Hedged Exposure 410.39 100.32

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 % hedged 50% 13%

Trend in hedging of exchange risk

 Gokaldas significantly increased its hedged exposure of its receivables from debtors. As
against 13% of its receivables hedged in 2007 , it hedged 50% of its receivables within 6
months at the end FY08

 Gokaldas changed its hedging strategy and hedged both in Euro(38%) & Dollar(62%) in
2008 as against hedging just in dollar in 2007

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Tata Consultancy Services

TCS hedges its currency risk by using forward contracts and options. It hedges its currency risk in
US Dollar, Sterling Pound, & Euro. TCS hedges its currency risk for debtors (fair value hedge) and
also hedges for its future revenue stream (cash flow hedge) with forward contracts & option up
to a maximum period of 8 years

Trends in hedging by TCS

 TCS used options(90%) much more than forwards(10%) to manage its currency risk in FY
07-08, may be as it wants to hedge against future cash flows for a long period
 Between FY 06-07 & 07-08 TCS increased its hedged exposure considerably both by
using forwards and options
 The absolute increase in forward contract was $280 million while hedged exposure
through options increased by $3171 million

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R Systems International Ltd.

R Systems has subsidiaries all over the world, therefore earns its revenues in different currencies
like EURO, SGD, AUD, JPY and GBP and carries significant amount of risk owing to fluctuations in
different currency. It uses only forward contracts to hedge against foreign currency risks and
does not hedge its risk through options (vanilla or exotic). R Systems hedges only in USD(dollars)

Following is the geographical break down of revenues earned :-

Revenues By Geography FY 2007 FY 2006

USA 70.53 73.22
SEAC 16.53 13.28
India 7.77 9.08
Others 5.17 4.42

Following are the income, debtors and hedged exposure of RSystem at end of FY 07 & 06:-

Amount in Crores FY 2007 FY 2006

Revenue 247 203
Debtors 61.35 48.33
Days Sales Outstanding ( in days) 78 82
Hedged Exposure 39.05 22.94
Hedged exposure on basis of days sales
O/s 50 40
Hedged exposure on basis of Debtors 81% 81%

 R Systems hedged its foreign currency risk on the basis on the debtors, hedging 80% of
its receivables
 In terms of days sales outstanding(DSO) R Systems hedged 50 days receivables in 2007
as compared to 40 days receivables in 2006
 R System has unhedged exposure in USD of 47.9 crores, in SGD of 17.1 crores, in Euro of
1.5 crores that could affect both translation & transaction loss
 R System hedges its risk only through forward contracts of USD and thus if the current
trend of USD appreciating more than other currency reverses, could pose serious
financial risk in future

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 R System does not uses options(vanilla or exotic) which other IT firms like Infosys, TCS
are using

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 Comparative Analysis of Different Companies on Various Parameters

Company Name Purpose Instruments Used Porportion & Trend Currencies

Hedged in
         
Infosys Hedging for Forwards Started using more USD, Euro
debtors off late as compared
to previous years
Options Was used more
Exotic(Range extensively in last
Barrier) financial year
Gokaldas Exports Hedging for Forwards Used Forward Only USD, SEK, JPY
debtors 
HCL Technologies  Hedging for Forwards Used Forward Only USD, JPY, SEK
debtors
Rsystems Hedging for Forwards Used Forward Only USD
debtors
TCS Hedging Future Forwards Used Forward to USD, Euro,
Cash Flows hedge currency risk GBP
in last Financial Year
but the proportion
was just to the tune
of 10%
Options Vanilla Increased the cash
flow hedging
through options by
more than 300% in
FY 07-08

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Interview with Manager

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1. Do you use hedging tools to manage currency risk? What are the different tools used by
your organization?

Being an IT company and earning more than 90% of our revenues in foreign currency
and most of the contracts with clients are in foreign currency, we are exposed to
significant amount of currency risk. Appreciation of as much as 1% of Indian rupee
against other currency can significantly impact our topline & bottomline. We use only
Forward Contracts to hedge our foreign currency risk, and our primary purpose is to
hedge for the receivables (billed or unbilled) and we don’t not indulge into hedging for
speculative purposes.

2. What is the reason behind using only forwards as a tool, there are a number of software
companies who are exposed to a variety of tools such as futures and options and even
exotic options to avert currency risk?

Its our company policy that we hedge using fair value approach and hence hedge our
most probable receivables and does not indulge into speculative hedging, and as far as
other companies are concerned, I believe after Hexaware and other companies had
considerable amount of losses due to getting stuck into exotic options, a lot of software
companies have taken a conservative stand on managing foreign currency risk

3. What is the time frame of your forward contracts?

The timeframe of our forward contracts is generally around 3-6 months as we don’t
hedge for future cash flows and limit ourselves to hedging against our receivables. So
the time frame depends on the receivables we have on our books

4. Is it in proportion to the average collection period?

Yes , the average collection period tend to get reflected in the amount of risk hedged,
but there are other elements too that come into play. So it is not solely dependent on
the average collection period

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5. What are the different currencies which your company is exposed to?

RSystems has 12 subsidiaries with development centers all around the world in
Singapore, France, Salt lake city, Tokyo, Bangkok etc. and receives its revenues from
different geographies So we are exposed to risk from various currencies like USD, Euro,
AUD, JPY etc

6. What are the different currencies that you place your hedges?

As we earn around 70% of our revenues in USD, the risk posed by fluctuations in dollar is
much as compared to other currencies, so as according to our company policy we place
our hedges only against USD. On the basis of discussion with bankers, the Company
assess that material risk which it carries is only the change in value of USD. The other
currencies are either appreciating currency such as EURO or exposure is considered
insignificant to cover under Hedge Policy. Therefore, the Company Hedge Policy at
present covers the risk of change in value of USD with respect to realization from
receivables.

7. What is the ratio of your hedging volumes with regards to your revenues?

The hedged exposure is not directly dependent on the revenues as we do not hedge
against future revenues but it depends on the debtors and the collection period of the
debtors, so we generally keep entering into small forward contracts over the year and
replace these with a big contract later on.

8. What are the different channels or institutions through which your company places its
hedges?

We buy forward contract through banks, and to avoid counterparty risk we tend not to
buy the entire forward contract from same bank.

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9. What are the costs involved in entering into a forward contract?

The cost depends on the banks/institution we enter a forward contract with. Banks have
different rates that vary marginally. Normally it comes around 2 paise per dollar

10. What are the factors you consider before entering into a forward contract?

There are various factors that we consider like the amount of debts, the quality of debts,
the future outlook of the currency

11. Do you even get into a contract when the dollar is expected to appreciate in the future?

The policy of company is to hedge its currency risk and in effect even if we have some
opportunity loss, but it does impact the amount of exposure we hedge.

12. Do you have an in house team which analyses and tracks the currency markets?

We do have our foreign currency risk management cell, that keeps track of our exposure
to different currencies and manages the risk, but we do take the expertise of other
agencies in regard to the outlook of currencies over medium to long term period to be
able to better hedge our exposure to different currencies

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Conclusion

Through this report we covered the topic of Currency Risk Management,

extensively. The purpose of this report was to show how different

organizations who deal in different foreign currencies manage their risk so

as to minimize the losses they could face due to volatility in the foreign

exchange rates.

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Bibliography

1. Managing Global Financial and Foreign Exchange Rate Risk by Ghassem A Homafair
2. Managing Currency Risk using foreign exchange options by Alan Hicks
3. Foreign Exchange Risk by S. Yadav
4. Financial Risk manager Handbook – Google Book Search
5. www.rbi.org
6. www.nseindia.com
7. www.investopedia.com
8. www.rsystems.com (annual report)
9. www.infosys.com (annual report)
10. www.tcs.com (annual report)
11. www.hcl.in (annual report)
12. www.gokaldasindia.com (annual report)
13. www.wikipedia.com

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