Urvija Vadilal

8/13/2019 Urvija Vadilal

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A

Project ReportOn

Undertaken at

VADILAL ENTERPRISES LTD.

In partial fulfillment of Summer Training (1styear MBA)

Submitted to

AES PG Institute of Business Management

Gujarat University

Ahmedabad

Submitted by

Urvija Shah (48)


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PREFACE

every field of education imparted to the student, working on project plays an

hen it comes to the practical knowledge in Financial field, there are number

ut amongst all these fields tremendous opportunities are residing in the

etting the deep and practical knowledge of this field can be of great help to

uly 20, 2006 Urvija Shah

In

immense role in bringing out and exhibiting the qualities which are helpful in

implementing students knowledge in the practical life.

W

of areas to be specialized in. one can go for core finance like working capital

management, Investment decisions, capital structure decisions, credit policies

etc, and one can look forward to equity and forex markets as well. Both are

important part of the Finance.

B

Foreign Exchange field. As in India, the FOREX system is main fundamental

thing for any kind of International business.

Gthe students who are interested in finance. This kind of training and projects

can help the students to use their theoretical knowledge on the practical

aspects of the field.

JAhmedabad


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ACKNOWLEDGEMENT

tudy of business management is all about gaining knowledge from the

was given this opportunity by one of the best Foreign Exchange Exposure

wish to express my heartfelt gratitude to Mr. ASPY Bharucha, President, and

also thank Dr. Mayank Joshipura for his kind help in the subject and I am

inally, not to miss anyone, I thank all the people who have directly or

rvija shah______________

S

experience one gets from the corporate world. When students get into the

corporate world to gain the knowledge, he is a novice. They need and

opportunity and of-course help of his/her senior to explore the aspects of

business management.

I

management companies: VADILAL Enterprises Ltd. I am obliged to

VADILAL Enterprises Ltd. for providing me an opportunity to undergo training

in their esteemed organization.

I

Mr. Victor Saldanha, Consultant Advisor, FOREX, VADILAL Enterprises Ltd

for their immense help in making my training and project fruitful. I would also

like to thank all the employees of FOREX division for their needed help.

I

thankful to all other faculty members at AES PGIBM for their kind support.

F

indirectly helped me a lot throughout the training period and in completion of

my project successfully.

U


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EXECUTIVE SUMMARY

The main plot for my project was to study Indian Foreign Exchange

hapter 1 contains some basic information on the Foreign Exchange. i.e. what

hapter 2 contains information about FOREX markets (Indian as well as global)

hapter 3 is built around the FOREX Market rates. The initial part is packed

OREX market is not a market where anyone who has money can come and

very business opportunity is combined with the risk. Chapter 5 gives us the

ow once we find out the risk in market, it is very much necessary to know, to

market. To find out the risk involved in the Foreign Exchange market and

to learn about the tools for managing FOREX tools.

C

exactly Foreign Exchange and what does it include as well as provide.

C

and its general workings (how it operates) and participants of the market.Getting this knowledge can help in detailed information in the next chapters. It

also contains basic information of modified Liberalized Exchange Rate

Management System

C

with the direct rate and indirect rate and how they are defined, then the cross

rate and the methods for calculating the same. Finally, the forward rate,

importance of the same for the importer and exporter and its calculations.

F

participate; it has its own guidelines. In chapter 4 these guidelines which are

necessary for FOREX market and which has been given by RBI are covered.

Also the guidelines given by FEDAI are included.

E

basic knowledge about all kind of risk which has been involved in the FOREX

market activities.

N

understand or say to learn how to manage that risk; so chapter 6 contains detail

about Risk Management procedure and tools/products in FOREX markets.


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RESEARCH M THODOLOGYE

Objective:

Foreign Exchange markets

Sub object

ding out risk involved in foreign exchange transaction

tools and techniques for managing

trategy for effective management

the advices or study outcomes

cope:

e project looks into the actual workings of VADILAL Enterprises Ltd.

ata collection:

ta collected from Vadilal Enterprises Ltd. regarding their

Main objective:

To study

To learn FOREX Risk management

ives:

Fin

of an organization.

Finding out various

foreign exchange risk.

Develop appropriate s

of foreign exchange risk.

To evaluate the effect of

in real time application in Vadilals client industry.

S

Th

In this Forex System study I tried to cover every objective of the

project, mentioned above and various aspects of the Forex Risk

Management. Scope of my project study is restricted to managing

Transaction Exposure part of Forex risk by using most effective

hedging tools.

D

Primary da

processes and secondary data from relevant literature along with the

websites are the main sources of information. The primary information

is collected through discussions with the personnel of Vadilal

Enterprises Ltd. and from the documents provided by them.


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Limitations:

nstraints

ts

ss operations

type of industry engaged in

Industrial Application:

With extinction of geographical boundaries and increase in foreign

Time co

Resource constrain

Confidentiality of busine

Restricted study of a particular

manufacturing and exports

trade each and every firm is facing more foreign exchange exposure

and thus foreign exchange risk they have ever faced. Though there are

many tools available for managing foreign exchange exposure nothing

comes without cost. So a business house has to find out a proper mix

of hedging tools which offers them maximum risk cover at minimum

cost and maximum flexibility. I have tried to make a humble attempt to

handle this one of the most important issue of foreign exchange risk

management. To fulfill my objective I have conducted a study of foreign

exchange risk management at Harsha Engineering Ltd


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TABLE OF CONTENTS

troduction to VADILAL Enterprises Limited

.

25

.

nnex Re

In. Introduction1

1.1 What is Foreign Exchange? 11.2 What does FX involve? 21.3 What does FX provide? 2

. Foreign Exchange market 32

2.1 Market participants 4

2.2 Indian FX market 62.3 Modified LERMS 8

3 Exchange Rates

3.1 Type of rates and its working 93.1.1 Direct rate 10

3.1.2 Indirect rate 103.1.3 Cross rate 113.1.4 Forward rate 13

3.2 Factors affecting exchange rates 21

. Guidelines4

4.1 RBI4.2 FEDAI 27

5 Export Finance 28

. Types of risk involved in FX market 306

f Risk management 347. Tools o. Development of appropriate strategy for Risk Management 548

8.1 Strategy development 558.2 Field Report at Harsha Engineers Ltd. 57

ure: ports provided by Vadilal Enterprises LimitedA

Bibliography

lossaryG


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INTRODUCTION TO VADILAL ENTERPRISES LIMITED

VADILAL ENTERPRISES LIMITED

FORE SIONwww.vadilalmarkets.comX ADVISORY & FFMC DIVI

VADILAL FOREX & FFMC Division provides customers who are engaged

ith the opening up of the Indian economy and financial markets several

reign Exchange Management, Commodity Market Advisory, is gaining

in Export / Import and trading in commodities a personal link with

markets.

W

changes have hit the market in recent past. Our country is now counted

among the developed countries in matters of current account transactions

scenario, treasury and financial markets, international trade and

commerce activities. Volatility world FOREX markets has increased

manifold. Foreign exchange valuation of the country depends upon

several factors in that fluctuation in exchange rate is now linked with

Currency Risk.

Fo

importance now a days on account of its complexity, as also requires

expert comments, advise, guidance, and also utmost importance in view

of the fact that the whole of FOREX and Commodity markets becoming

very closely integrated. Treasury Management concept has been

accepted by large organizations. Forex Advisory as a tool is also

accepted widely by Exporters, Importers and Commodity Traders,

because of timely and appropriate advice in relation to movements of the

currency, commodity and money markets.


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VADILALFOREXoffers different area of services to suit most Exporters

and Importers, those engaged in trading / imports of Metals [Base and

Minor] and Precious Metals Gold / Silver. The FOREX Division offers

the area of service in relation to:

FOREX Advisory and FOREX EXPOSURE MANAGEMENT to

Importers and Exporters. A thorough service connected with Banking,

ECD-RBI, FEDAI rules and guidelines, etc.

LME-METAL Advisory service of most base metal quotes at LME,

COMEX, NYMEX, Shanghai, markets, and complete guide and

informative service on forward, futures and relative data.

BULLION Informative service of Gold, Silver, and Precious metals on

International trading, quotes, rates, forwards, futures, etc., on various

international markets, inclusive of COMEX/NYMEX;

Vadilals business motto

TO UPDATE YOUR NEEDS AND REQUIREMENTS

&

BRING GLOBAL MAREKT CLOSER TO YOU

PERSONNEL:

A team of experienced, competent, qualified and, professional staff

consisting of ex-bankers with Treasury Management experience both

in India and abroad, Analysts, qualified Chartered Financial Analysts

(CFA), MBAs; Post Graduates, etc.

The Team is totally dedicated and committed to provide exclusive

guidance and advice to all its customers in relation to the area of

activities listed above.

INFRASTRUCTURE:

TELERATE Money line service.


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FOREX ADVISORY AND EXPOSURE MANAGEMENT service segments

Access to websitevadilalmarkets.com on a continuous process of

up-gradation of quotes of crosses, Indian Rupees, news,

comments, etc.

FOREX (daily four reports)* at different time zones to carry all

related information on INRupee, Cross currencies, forward

positions and relative information on Money and Stock Markets. All

4 reports are provided on e-mail, and on web-site, and also

includes important one at 10.30 morning on fax to attract direct

attention;

Weekly, Monthly reports; [conversion rates, bank reference rates,

Customs rates, FEDAI rates, etc.,*

Periodic Forex up-dates, EXIM up-dates, etc.

Exposure Management (on confirmed arrangement) taken well

care of exposure by experienced staff having banking knowledge

and expertise;

Arrangement on Import Bill discounting, for exports - Forfeiting and

Factoring, and ECB arrangement at the concessional service cost.

* All the reports are attached as annexure

ADDITIONAL SERVICE:

On-line service (real time value information) to ascertain level of

the currencies, forward differences, etc., between 9.30 am till

closing of NY markets.

Response to any query on FOREX related matter linked with

Banking, RBI, FEDAI rules, etc.,

In-house session on FOREX and Risk Management in relation to

banking, RBI and FEDAI directives and EXIM related matters,

Workshops Seminars on periodic basis on Foreign Exchange

and Risk Management and EXIM related matters.


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FFMC = FULL FLEDGED MONEY CHANGER

RBI authorized FFMC agent to release foreign exchange

entitlements; in relation to Business Travels, and BTQ : Basic Travel

Quota (general permission)

Authorized to sell financial products of AMEXCO American Express

Banking Travel Related Service.

SERVICE OFFERED with

Value Added, High-Tech Sophistication, and personalized

professionalism


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What is Foreign Exchange?

Countries of the world have been exchanging goods & services amongst

themselves from time immemorial. The world has come a long way from the

days of barter trade. With the inventions of money, the rigors & problems of

barter trade have disappeared. Barter trade has made way to exchange of

goods & services for money instead of exchange for other goods & services.

As every sovereign nation has a distinct national currency, international trade

has involved exchange of currencies. It is said that although the business of

changing money is as old as money itself, the foreign exchange markets

where currencies of different countries are exchanged, started taking shape

only in late nineteenth century. The exchange of currencies has brought about

the concept of exchange rates.

Like any other commodity, the price of one unit of foreign currency can be

stated in terms of domestic currency; in fact a unit of one currency can be

stated in terms of any other currency. Rate of exchange means the price of

one currency in terms of other currency. To state differently, the exchange

rate is said to be the rate at which a number of units of one currency can be

exchanged for a number of units of another currency. Simply defined,

exchange rate is nothing but value of one currency expressed in terms of

another currency. For example, the price of US Dollar (USD) of Japanese Yen

(JPY) or Pound Sterling (GBP) can be expressed in terms of Indian Rupees

(INR). Thus, if we say USD 1 = INR 47.00. It means the exchange of US

Dollar & Indian Rupees is 1:47.00. Similarly, GBP 1= INR 77 meaning that the

exchange rate of Sterling Pounds & Indian Rupee is 1:77.

Different countries have adopted different exchange rate system at different

times.


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What Does FX Involve?

A foreign exchange deal involves:

Exchange of two currencies

As an agreed exchange rate

For a specified settlement date

Settlement instructions for receipt and payment, and

Confidence that the terms of the trade will be adhered to i.e. limits

What Does FX provide?

Foreign exchange provides us:

The method or mechanism to conduct and settle the proceeds of

international trade

The means to obtain / provide technology, expertise and the sharing of

information

The means to minimize the risks of currency fluctuations primarily

through the use of various tools and financial instruments, and

Trading opportunities to generate incremental income.


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For any currency the main foreign exchange market is the country's financial

centre - viz. for genuine, trade related corporate business. This is the centre

where the country's central bankers and monetary authorities determine and

implement their monetary policies, its investment strategies and above all its

intervention polices to ensure stability in its currency markets. This is the

centre where the country's business leaders transact their trade related

financial deals and where the rest of the world comes to as a last resort to

cover its requirements.

However, for major world currencies, the world is a 24 hour market thatstretches from Wellington to Los Angeles. In this global marketplace there are

certain major trading centers called "money centers" and these are Tokyo,

Hong Kong, Singapore, Bahrain, London, Frankfurt, Zurich, New York and

Los Angeles.

The FX Market is a facilitating mechanism through which currencies are

exchanged. It comprises FX traders connected across the world through an

advanced telecommunication network


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MARKET PARTICIPANTS

(I) Corporate Customers

Institutional and Individual Customers, Exporters, Importers, Foreign Currency

Borrowers and Lenders, Investors and Fund Managers all form corporate

customers. These players can be major participants in markets where there

are exchange controls and restricted currency trading.

(II) Banks

Banks are the most active market participants. They essentially perform the

task of market makers. With their ability to take on foreign exchange positions,

they can quote prices for their own account. They have the communication

network, branches, support from exchange brokers, access to overseas

markets and limits with overseas banks which enable them to be market

makers. In India, RBI license to engage in FX transactions is required and

those that are granted this license are called Authorized Dealers. The

authorized dealers collectively constitute the Interbank Foreign Exchange

(FOREX) market in India.

(III) Central Banks

Central Banks world-wide are entrusted the responsibility of determining and

monitoring the external value of the currency of the country. The main role of

the Central Bankers is to avoid volatility, instability and wild fluctuations in theFX markets. To this end, Central Bankers, from time to time, are key players

in FX markets.

(IV) Exchange Brokers

Exchange brokers provide an important service to FX markets all over.

They are instrumental in bringing buyers and sellers together by providing

rates, market information and their network across various centers. Forex


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brokers generally deal with banks. In India, they are not allowed to deal on

their own account.

(V) Overseas FX Markets

FX markets world-wide have an astronomical turnover which is estimated to

run into hundreds of billions of dollars. Of the total volume of FX trade,

genuine corporate demand is estimated to constitute only around 5% of the

total volume. The FX market is largely supported by a very advanced

communication network which not only provides uninterrupted information on

world currencies, economies, politics and the like, it also is characterized by a

very large number of participants. This is what gives the market the depth andthe clout it has. Some of the most popular communication systems available

in the market today are Reuters Information Service, Telerate, Reuters

Technical Analysis, Reuters TV, Knight Ridder, Reuters Dealing System etc.

(VI) Speculators

Speculators are in the market mainly to generate trading income. The growth

in volumes, better communications, pressures to constantly generate profits

and a general improvement in competence have all contributed to see the

emergence of the speculators as a force to reckon with. Banks and corporate,

at different times, can be speculators as well.


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INDIAN FX MARKETS

Foreign Exchange business in India is regulated closely by the RBI. With

Exchange Control Regulations, the RBI ensures that involvement in the

Foreign Exchange business is restricted to certain sections of the business

community only.

The main market participants here are:

1. Corporate: Importers, Exporters and Customers for genuine trades or

merchant transactions.

2. Banks: One authorized dealer dealing with another to generate profit

or cover its open exposure.

3. Overseas Traders: Banks in India are permitted to buy and sell

currencies abroad in cover of customer requirements. They have very

recently been permitted to initiate positions abroad too. Overseas

banks call banks in India to cover their Indian Rupee requirements.

4. Authorized Dealers v/s RBI: This occurs only when the RBI

intervenes in the market and not in the normal course.

RBI restrictions in terms of participation in foreign currencies can be

summarized as under.

Corporate: Individuals as per the Exchange Control Manual (Retail)

Importers, Exporters and Borrowers of Foreign Currencies

(Wholesale)

Banks/Others:Money Changers (RMC's and FFMC's) licensed by the RBI to buy/sell

Foreign Currency Notes and Travelers Cheque from individuals

(Retail)

Banks licensed by the RBI, to carry out foreign exchange business on

a Commercial wholesale level, called Authorized Dealers.

Brokers:

Brokers are permitted to bring together buyers and sellers but cannot

trade for their own account. This means they have to strike the deal

with the buyers and sellers simultaneously.


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The Indian FX Market has seen a remarkable growth in the last few years.

The reasons for are:

Relaxation of controls by RBI and permitting banks to deal freely in the

Inter-bank market - this essentially is the process of economic reforms.

Better communication and availability of information - Reuters,

Telerate, Knight Ridder, RTA, Dealing System, Swift etc.

A virtual explosion in volumes in global FX market and Indian markets

follows suit.

General improvement in competence, freehand to trade and generate

incremental income and

The likelihood of full convertibility of rupee in the near future.


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MODIFIED LIBERALISED EXCHANGE RATE MANAGEMENT SYSTEM

In the process of liberalization it was decided by RBI to make the Rupee fully

floating with effect from March 1, 1993. The new arrangement is called

Modified LERMS. Its salient features are as under:

Effective March 1, 1993, all foreign exchange transactions, receipts and

payments, both under current and capital accounts of balance of payments

are being put through by authorized dealers at market determined exchange

rates. Foreign exchange receipts and payments, however, continued to be

governed by Exchange Control Regulations. Foreign exchange receipts are to

be surrendered to the authorized dealers except in cases where the residents

have been permitted by RBI to retain them either with the banks in India or

abroad. Authorized dealers are free to retain the entire foreign exchange

surrendered to them for being sold for permissible transactions and are not

required to surrender to the Reserve Bank any portion of such receipts.

Reserve Bank of India, under Section 40 of RBI Act, 1934, was obliged to buy

and sell foreign exchange to the authorized dealers. Reserve Bank is now

required to sell any authorized person at its offices/branches US Dollars for

meeting foreign exchange payments at its exchange rates based on the

market rate only for such purposes as are approved by the Central

Government. The RBI buys spot US Dollars from authorized dealers at its

exchange rate. Reserve Bank does not ordinarily buy spot Pound Sterling,

Deutsche Mark and Japanese Yen. It does not buy forward any currency. Theexchange rate at which the RBI buys and sells foreign exchange is in the

5% band of the market rate. Also, the RBI announces the reference rate at

12:00 hours which is the rate at which transactions with IMF/IBRD etc. are

undertaken.


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EXCHANGE RATE ARITHMETIC & MARKET CONVENTION

The FX market is characterized by professional and competitive participants

who always quote a two way price i.e. buying rate and selling rate.

Bid rate: The buying rate

Ask or Offer rate: The selling rate

Spread: The difference between the Selling rate and the buying rate

Market participants expect to make a profit by trading in the FOREX market

and this is reflected in the spread. How wide or narrow the spread is, is a

function of the competitiveness and the volatility in the markets.

TYPES OF RATES

There are mainly four types of rates:

1. Direct rate

2. Indirect rate

3. Cross rate

4. Forward rate

1. Direct rate:

Direct rate is an example of the value of foreign currency in domestic currency

terms. For example,

1 USD = INR 46.40 1 GBP = INR 78.00

100 JPY = INR 40.46 1EUR = INR 58.00


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2. Indirect rate:

Indirect rate is an expression of the value of domestic currency in foreign

currency terms. Indirect rates are also known as reciprocal rates. For

example,

100 INR = USD 2.1368 100 INR = GBP 1.298

100 INR = JPY 250.63 100 INR = EUR 1.8265

The direct rate for one country becomes reciprocal for the corresponding

country.

In international markets though, practice is to quotes rates for a unit of

USD in terms of the other currency, such as

1 USD = CHF 1.2285 1 USD = CAD 1.2600

1 USD = JPY 107.50 1 USD = SAR 3.7500

1 USD = INR 46.23

There is an exception to this rule though in the case of just 4 currencies

GBP, EUR, AUD & NZD

Market practice is to quote the value of these currencies in terms of USD. Forexample,

1 GBP = USD 1.8285 1EUR = USD 1.2585

1 AUD = USD 0.7610 1NZD = USD 0.7135


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3. Cross rate:

Cross rate is an expression of the value of one foreign currency versus

another foreign currency neither of which is a domestic currency. For

example,

USD / CHF = 1.2900 USD / JPY = 117.35

EUR / USD = 1.1700 etc.

These would all be cross currencies for us in India as neither of the currency

in the set is Indian Rupee. However in international markets cross rates refer

to those where neither of the currency is the USD.

To calculate the cross currency rate care should be taken to determine the

following:

The terms i.e. the base currency and the foreign currency

The rates to be used i.e. bid or offer rate

The method of conversion i.e. divide or multiply

Suppose we have following rates on a given day in the local market:

USD/INR = 46.80 GBP/INR = 77.00

CHF/INR = 36.30 EUR/INR = 54.75

To work out the cross rates versus USD for say CHF we would have to:

(I) Determine the terms i.e. we need to find out say USD/CHF. So CHF

is the base (or domestic) currency and USD is the foreign currency.

This is popularly called CHF terms.

(II) Next the rates to be used i.e. USD/INR and CHF/INR. This is

particularly important where we have bid/offer rates. Care should be

taken to use the correct bid rate for one and the offer rate for the

other to derive at the cross rate.


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(III) Finally, the conversion method. i.e. divide the USD/INR rate by the

CHF/INR

Expressed in the formula this is:

CHF 36.30 = INR 46.80 = USD 1

So, USD 1 = 46.80 36.30 = 1.2892

USD/CHF = 1.2892

Now suppose we have USD/INR 46.80 46.85 (bid/offer) and the CHF/INR

36.27-36.32 (bid/offer). To work out the cross bid/ offer rates for USD/CHF,

the rates to be used are:

For, USD/CHF bid rate use 46.80 (bid of USD/INR) and 36.32 (offer of

CHF/INR) So, 46.80 36.32 = 1.2885

For, USD/CHF offer rate use 46.85 (offer of USD/INR) and 36.27 (bid of

CHF/INR) So, 46.85 36.27 = 1.2917

It is important to remember the market convention when it comes to quoting of

exchange rates. Some currencies are quoted to 2 decimal points such as

USD/JPY and the erstwhile USD/ITL, some to 5 decimal points such as

USD/KWD, USD/BHD, while most of the others are quoted to 4 decimal

points. As a rule of thumb, most currencies with a low absolute value to the

USD are quoted to 2 decimal points; those with a high absolute value are

quoted to 5 decimal points and the rest to four decimal points.

Settlement Date

FX Contracts have to be settled and currencies exchanged. Normal market

practice is to settle FX Contracts on a T+2 basis, i.e. 2 working days after

transaction date. This is called Value Spot. All market quotes are for Value

Spot.


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4. FORWARD POINTS:

Forward point is the adjustment made to the spot rate to derive a forward

exchange rate. As we know market rates are quoted for value spot. But where

an exchange has to be made for a forward date, an adjustment has to be

made to the spot rate. This adjustment depends on whether a currency is at a

premium, discount or par in relation to the corresponding currency in the

exchange.

Forward points reflect, in the long term, the interest rate differential between

the currencies for the different settlement / value dates.

The factors that determine the forward points are:

Demand and supply of the currency for the particular settlement date.

Market expectations over the given period both in the FX and interest

rates.

Interest differentials between the currencies, for the period involved.

In the case of direct quotes, premium is positive forward points while discountis negative forward points and par reflects no forward points.

FORWARD FOREIGN EXCHANGE RATES

Forward FX rate is the rate at which exchange of currencies take place for the

agreed forward date.

A forward rate has two components:1. Spot rate

2. Forward Points

Where there are no restrictions on capital flows, the only factor determining

forward points is the interest rate differential between the currencies involved.

How do Forward Points arise?

Suppose market rates are as follows:

Spot USD / CAD = 1.3500


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1 year USD interest rates = 1.25% and

1 year CAD interest rates = 3.00%

1 year forward USD/CAD = 1.3500

To take advantage of this interest rate differential one would

Borrow USD on spot @ 1.25%

Convert the USD to CAD @ 1.3500

Lend CAD for 1 year @ 3.00% and

Reconvert CAD back to USD on maturity @ 1.3500

The cash flow from these transactions would be as under:

USD CAD

+ - + -

Borrow USD on spot @ 1.25% 1000.00

Spot FX @ 1.3500 1000.00

Lend CAD on Spot for 1 year @

3.00%1350.00

Interest Flows 12.50 40.50

P I on maturity 1012.50 1390.50

FX on maturity @ 1.3500 1030.00 1390.50

NET 17.50 0 0 0

The example suggests one who borrows USD 1000.00, coverts to CAD, lends

the CAD and converts back to USD on maturity makes a profit of USD 17.50.

The market, in such a situation, provides what is called an arbitrage

opportunity, i.e. an opportunity to take advantage of various markets,

currencies or products to generate risk free profit. This cannot last long

because every speculator would do the same while no one would want to lend

USD or sell CAD. Alternatively, every lender of USD would demand a rate

higher than 1.25% and no borrower of CAD would pay 3.00%. There would be

a series of corrections or amendments till equilibrium is reached.


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The change could be in any of the following areas:

USD interest rates moving higher

CAD interest rates moving lower

Forward rate moving towards it being (P + I of DC) (P + I of FC)

More accurately, there is fundamental flaw in this example i.e. the

assumptions that the Forward FX rate is the same as Spot rate.

The forward rate has to reflect the interest differentials and a true forward FX

rate for USD / CAD would take into account the total CAD inflow and total

USD outflow.

Therefore the FX rate USD/CAD 1 year forward would be

USD 1012.50 = CAD 1390.50

USD 1 = 1390.50 1020.50

= 1.3733

We now have the following:

Spot USD/CAD = 1.3500

Forward USD/CAD = 1.3733

Forward points = Forward rate spot rate

= 1.3733 1.3500

= +0.0233

In our example, USD is at forward premium to the CAD (as forward USD/CAD

is higher then Spot USD/CAD) and the CAD at a discount to the USD.

Because always FR > SR it means DCIR > FCIR and foreign currency is at

premium and domestic/base currency is at discount.

Since USD/CAD @ 1.3500 is a direct quote, we add the premium to the spot

rate to give us the Forward FX rate.


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CALCULATION OF FORWARD POINTS

The formula for calculation of forward points is:

Forward points = (spot rate interest differential period 100) Basis

Where, interest differential is Domestic Currency Interest Rate Foreign

Currency Interest Rate.

This formula, called the Interest Rate Differential Method, is used widely in

Indian markets. The formula takes into account interest rate differentials as

opposed to total inflows and outflows. Besides, the formula has an

assumption i.e. the basis for the two currencies are the same. This, we

have seen, is not always the case, a classic example being USD versus

Indian Rupees. US Dollars having a 360 day basis and the Indian Rupees

having a 365 day basis. The forward point worked out using this formula is not

accurate.

If we apply the formula in our earlier example we would have:Forward points = 1.3500 1.75 100 = 0.0236

Which is quite different from that we worked out earlier i.e. 0.0233

The more accurate formula id one which takes total inflows and outflows into

account called the Round Robin Method. Where,

Forward rate = {(Domestic Currency P + I) (ForeignCurrency P + I)}

Where, P represents the Spot Values of the respective currencies and

I is the interest amount over the period.

While calculating the interest for the currencies care should be taken while

using the basis and the actual number of days involved.


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Forward Rate = Spot Rate + Forward Points, and

Forward Points = Forward Rate Spot Rate

As in Spot rates, forward rates too are quoted for buying and selling i.e. Bid /

Offer rates. Both of these rates are quoted in points of the spot / forward

rates. However, in the case of Forward Rates the forward points reflect the

premium or discount, as the case may be. As we know premium is added to

the spot rate and discount is deducted from the spot rate. In the case of

premium, the bid rate is lower than the offer rate. Whereas, the way market

quotes rates, bid rate appears to be higher than the offer arte in the case of

discount.

CROSS FORWARD FX RATES

The principle is exactly the same as the spot cross rates but care should be

taken while adjusting for forward points. For example,

Spot USD/INR = 46.80/46.85

Spot CHF/INR = 36.27/36.32

So, Spot USD/CHF = 1.2900/1.2905

3 months USD/INR Forward Points = 5/7

3 months CHF/INR Forward Points = 25/30

So, 3 months Forward USD/INR Rate = 46.85/46.92

3 months Forward CHF/INR Rate = 36.52/36.62

3 months Forward USD/CHF Rate = 1.2794/1.2848

From these rates we can also work out 3 months USD / CHF forward points

Forward Rate Spot Rate = Forward Points

1.2794 1.2900 = -0.0106, and

1.2848 1.2905 = -0.0057

Based on this market quote 3 months USD / CHF would be 106/57


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Forward Rates

Where settlement is sought for any date other than Spot, the applicable rate is

not the Spot Rate. An adjustment arises due to differences in interest rates inthe currencies involved. The forward value of a currency may be higher

(premium), lower (discount) or the same (par) as the Spot Value

The forward value is a function of the Interest Rate Differential in the

currencies. Therefore, to calculate the forward rate, it is necessary to know

the prevailing interest rates for the duration.

Interest Differential (or Annualized Premium) is INR Interest Rate (DCIR)

minus FC Interest Rate (FCIR)

The formula for Forward Rate is:

SR + {(SR x ID xDuration) 365}

Say Spot USD/INR = 43.50,

3 months Annualized Interest Rates for USD 3.30% and INR 4.50%

ID = DCIR FCIR = 4.50% - 3.30% = 1.20%

FR = 43.50 + {(43.50 x 1.20% x3) 12}

Then FR = 43.50 + 0.1305 = 43.6305

Likewise forward rates can be calculated for any duration, from 1 day to 6

months and beyond. All one needs to know is the interest rates in the

currencies or the Interest Differential, but there exists a vibrant forward market

where rates are available for month-ends of successive calendar months

There may be instances when a requirement is not for a month-end.

An exporter has a receivable or an importer a payable for say 11th August

2005. Forward rates available are for 29th July and 31st August of 43.60

and 43.65. To calculate the rate for 11th August one merely needs to

extrapolate the rate

So {(43.65 43.60) 33} x13 = 0.0197


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You need to add this adjustment to the earlier date rate, i.e., of 29th July

43.60 + 0.0197 = 43.6197, the rate for 11/08

This is market practice for calculating what is called broken date forward

ratesby the extrapolation method

Prior to Spot

Often a corporate needs to settle a contract immediately, i.e. even before

Spot Value

For example, say today is 1st June so Spot Value is 3rd June and an exporter

receives proceeds today. He has not covered the exposure as yet and needs

to convert today. The bank would calculate the 2 day adjustment from 3rd to

1st JuneThe calculation is the same as for any other forward using the sameformula. However since the adjustment is for a date prior to Spot the

adjustment has to be reversed

Premium has to be deductedfrom the Spot Rate and Discount added to the

Spot Rate. This is what is known as Cash-Spot.

Similar would be the treatment when an adjustment is to be made to 2nd

June, i.e. a 1 day adjustment. The settlement for 2nd June is popularly known

as Tom-Spot

As in Cash Spot, for Tom-Spot too, the Premium is deducted from and

Discount added to the Spot.


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Rates for an Exporter

An exporter needs to sell FC to the bank. The bank will quote its Bid (Buying)

Rate, the lower rate. Where an exporter wants to sell forward, the bank would

quote the forward bid rate. To an exporter the bank quotes its buying rate for

Value Cash where proceeds come in and the same has not been covered as

yet

Rates for an Importer

An importer needs to buy FC from the bank to pay for the import. The bank

will quote its Offer (Selling) Rate, the higher rate. Where an importer wants to

buy forward, the bank would quote the forward offer rate. To an importer the

bank quotes its selling rate for Value Cash where immediate payment has to

be made and the same has not been covered as yet.


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FACTORS AFFECTING EXCHANGE RATES

The Bretton Woods conference in July 1944 resulted into a new monetary

order. The main objectives of this were to establish an international monetary

system with stable exchange rates, to eliminate exchange controls, and to

bring about convertibility of all currencies. This required the central banks of

various countries to declare their parity to gold or to the US Dollar. In turn,

USA agreed to exchange US Dollar for gold at 35 dollars per ounce. The

Central banks were expected to keep the rate fluctuations within 1%.

However, due to chronic US balance of payments deficits there was a general

loss of confidence in the US Dollar. This culminated in the demise of the

Bretton Woods System in 1971. At the monetary conference held on

December 17 and 18, 1971, a new arrangement, popularly known as

Smithsonian Agreement was at. Under the system intervention points range

was widened to 2.25%. However, as the USA had done away with the

convertibility of Dollars into Gold, the arrangement under Smithsonian

Agreement could not continue for long and ultimately in 1973 many countries

started floating their currencies. This development gave rise to fluctuatingexchange rates. Although in a free market it is the demand and supply of the

currency which should determine the exchange rates there are many more

factors responsible for these fluctuations. The volatility of exchange rates

cannot be traced to a single reason and consequently it becomes difficult to

precisely define the factors that affect the exchange rates. However, the

important among them are:

(I) Balance of payments

Balance of payments position of a country is a definite indicator of the

demand and supply of foreign exchange. If a country has a favorable balance

of payments position it implies that there is more supply of foreign exchange

and therefore foreign currencies will tend to be cheaper vis--vis domestic

currency. However, if balance of payments position is unfavorable, it indicates

that there is more demand for foreign exchange and this will result in the priceof foreign exchange vis--vis domestic currency firming up.


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(II)Strength of the economy

The relative strength of the economy also has an effect on the demand and

supply of foreign currencies. If an economy is growing at a faster rate it is

generally, in the long-run, expected to have a better performance on balance

of trade. However, in the short run increasing economic activity in the country

may necessitate higher imports and exports may take sometime to increase.

The economic growth is indicated by various parameters like relative rate of

growth in industrial production and capacity utilization, rate of increase in

Gross National Product and fall in employment rate, etc.

(III)Fiscal policy

The fiscal policy followed by government has an impact on the economy of

the country which in turn affects the exchange rates. If the government follows

an expansionary policy by having low interest rates, it will fuel the engine of

economic growth and will lead to better trade performance. However, a word

of caution is necessary here. If the government is following an expansionary

policy by resorting to high budget deficit and monetizing the deficit, this will

lead to high inflation in the economy. This will prove to be counter productive

as far as growth in exports is concerned.

(IV) Interest rate

High interest rates make the speculative capital move between countries and

this affects the exchange rates. The capital is attracted, provided there are no

controls towards currencies yielding high interest rates. If interest rates of

domestic currency are raised this will result in more demand for domestic

currency and more supply of the foreign currency, thus making the latter

cheaper vis--vis the former.

(V) Monetary policy

The central banks of various countries have a control on the monetary policy

to be pursued although it is generally in consonance with the fiscal policies of

the government. Monetary policy is a very effective tool for controlling money


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supply, and is used particularly for keeping a tab on the inflationary pressures

in the economy. The main objective of the monetary policy of any economy is

to maintain the money supply in the economy at a level which will ensure

price stability, full employment and growth in the economy. Pursued by the

central bank, it also gives a hint about the future interest rates. If the money

supply in an economy is more it will lead to inflation and the central bank will

raise interest rates, sell government securities through open market

operations, raise cash reserve requirement thus giving a signal for tight

money supply policy. On the other hand, to spur the growth in the economy

the central bank may lower interest rates, buy government securities in the

market, and lower the cash reserve requirements thus heralding an era of

easy monetary policy. This will be a sign for low interest rates in future. It will

be clear from the above that monetary policy influences interest rates,

inflation, employment, etc. and consequently, affects the exchange rates.

(VI) Political factors

If a change is expected in the government on account of elections or if there is

change in the incumbency in the government, the exchange rates may be

affected. Market thrives on stability and any perception of political instability is

sufficient to move exchange rates significantly. However, whether the

currency of the country concerned will become stronger or weaker will depend

upon expected policies to be pursued by the new government which is likely

to take over. But there are some currencies, like the US Dollar, Swiss Franc

etc. in which people have confidence and at times of any international crisis

foreign funds move into these currencies. These are known as safe

havencurrencies. War also affects the exchange rates of the currencies of the

country involved. Sometimes it affects the currencies of other countries too.

(VII) Exchange control

Exchange control is generally aimed at disallowing free movement of capital

flows and it therefore affects exchange rates. Sometimes countries exercise

control through exchange rate mechanism by keeping the price of their

currency at an artificial level. If a country wants to give a boost to exports, it


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will keep the value of its currency low vis--vis the foreign currency. This will

help exporters in realizing more units of the local currency for the same units

of foreign currency received by them as export earnings. However, reverse

would be the case if the government decides to follow a liberal import policy.

(VIII) Central Bank intervention

Buying or selling of foreign exchange in the market by the central bank with a

view to increase the supply or demand, thereby affecting the exchange rates

is known as intervention. If a central bank is of the opinion that local currency

is becoming stronger thereby affecting the exports, it will buy foreign currency

and sell local currency. It will increase the demand for foreign currency andthe rates of foreign currency vis--vis local currency will go up. However, if the

rate of exchange is kept artificially at low levels, it tends to accelerate inflation.

Therefore, the central bank has to take into consideration many factors before

intervening in the market.

(IX) Speculation

In FOREX markets, a dealer taking speculative positions is common. If a few

big speculative operators are buying/selling a particular currency in a big way,

others may follow suit and that currency may strengthen/weaken in the short

run. This is popularly known as the bandwagon effectand this can affect

exchange rates significantly, particularly in the near term.

(X) Technical factors

Technical factors particularly in the short run can influence exchange rates. If,

for example, regulations by the central bank make it necessary to limit the

size of open position and if banks have a big short position, they may, in

order to cover such a position, buy foreign exchange. This will result in higher

short-term demand which is not genuine. Similarly, reserve requirement of the

central bank may also create a technical position thus influencing the

exchange rates.


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RBI (RESERVE BANK of INDIA) Guidelines

1. Category Exporter

Importer

Foreign Currency Borrower

2. Currency Blanket Permission. The currency which has no blanket

permission has to go through RBI reference or say RBI reference is

necessary for those currencies for doing any kind of trading. The

currencies with blanket permission are USD, EUR, GBP, CHF, JPY,AUD and CAD. These currencies are used for payment of Imports;

accept of Exports and for borrowing.

3. Trade Amount (expect for borrower)

4. Duration

On the date or above the starting period and before the end date

5. Speculation

No speculation is allowed as per RBI

6. Trading

Exporter he has receivables so if foreign currency goes up he

has profit and if FC goes down than it is risk for him. An

exporters risk starts on receipt of an export order or an Export

L/C. Risk ends when payment is due; On shipment (DP Basis)

or end of credit period (DA Basis)

Importer he has payment to make so if foreign currency goes

down he has profit and if FC goes up than it is risk for him. An

importers risk starts on placing an import order or opening of

Import L/C and it ends when payment is due, either on receipt of

documents (DP Basis) or end of credit period (DA Basis)

RBI permits importers and exporters to hedge their exposures

(partial or full) at any time from the commencement to the

termination of the FX risk


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Banks are authorized to provide cover against confirmed orders

or L/C. They may also quote rates against past performance

RBI also permits exporters/importers to hedge their exposures

against cross currencies. Trading in cross currencies requires a

thorough understanding of currency markets and a pro-active

participation in the market


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F E D A I - FOREIGN EXCHANGE DEALERS ASSOCIATION OF INDIA

Foreign Exchange business in India was confined to few foreign banks only

till the period 1959. The said group banks were known as Exchange Banks.They had formed an Association, which was known as the "Exchange

Banks' Association". It was mainly covering the areas of activities within

Bombay (now Mumbai), Calcutta (now Kolkata), Madras (now Chennai),

Delhi and Amristsar. On introduction of the exchange control in India during

1939, the said Association was functioning within rules framed by RBI. The

rules and regulations - introduced and practiced were also covered by RBI

approval. On account of expansion in the foreign trade, and business, RBI

allowed schedule commercial banks also to undertake foreign exchange

transactions. Those banks which were allowed and permitted by RBI to deal

in foreign exchange transactions were known as AD - Authorised Dealers.

The FEDAI - Foreign Exchange Dealers' Association of India was formed

with approval of RBI during August 1958. It was under ECM-RBI directives

under reference ECS/198/86-58-Gen dated 16th August, 1958, authorized

the banks to handle foreign exchange business.

All Public sector banks, foreign banks, private sector and co-operative banks

and certain Financial institutions are the members of FEDAI. FEDAI is a

non-profit making Association and relative expenses are shared by all its

member banks. FEDAI acts as a facilitating body and in consultation with

Reserve Bank of India, frames rules / regulations for AD in India for conduct

of the foreign exchange business related transactions.

FEDAI is the Association of the member Banks. Naturally, the guidelines and

rules prepared were of interest of the member Banks. However, on account of

liberalization and reforms introduced during 1991 to boost the foreign trade to

and fro India, it becomes imperative by FEDAI to review Rules and

Guidelines. FEDAI has also taken due care of the interest of both Importers

and Exporters while revising rules and guidelines.


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To promote exports the RBI has directed commercial banks to offer export

finance at subsidized rates. But export finance is of course subject to the bank

sanctioning such a facility. Exporters must approach their bankers in advance,

to get the limit approved

Banks provide finance, both before and after shipment, to facilitate

exports.

Export finance is given for the purpose of procuring raw materials,

process, production, packing and shipment of goods for exports

The subsidy that is available is conditional on actual exports

Pre-Shipment Finance

Finance that is given for procuring raw materials, production, packing

and shipment is classified as Pre-Shipment Finance or Packing Credit

Banks normally provide packing credit only against confirmed Letters of

Credit which have to be lodged with the bank. For prime clients, banks

offer Packing Credit against export orders, as well.

Pre-shipment finance has to be liquidated by submission of documents

evidencing exports

Post-Shipment Finance

When an exporter-borrower submits export documents to liquidate

Packing Credit, banks either purchase or negotiate or discount these

documents.

This is referred to as Post-Shipment finance

This finance has to be liquidated from export proceeds received from

abroad, through banking channels


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Export Finance

Export finance can be availed of either in rupees (EPC) or in the

foreign currency (PCFC) of invoicing

PCFC is cost-effective as borrowing cost in FC is generally lower than

those in rupees but this is subject to availability of foreign currency with

the commercial bank

Availing export finance in foreign currency liquidates the FX Risk

On the other hand when packing credit is taken in rupees, the exporter

still needs to convert the foreign currency when the proceeds come in.

The FX Risk therefore remains open

The RBI subsidizes the rate of interest on export finance

Export Finance Rates

The lending rates for export finance is linked to market rates; PLR in

the case of Rupees and LIBOR for foreign currencies (PCFC).

Since RBI subsidizes the rate, rupee finance can be obtained at sub-

PLR. No subsidy is available when export finance is availed in foreign

currency

But given current market scenario it is possible to reduce the borrowing

cost to below rupees when availing PCFC

An example would clarify the point better

Rupee PLR 10.00% less 2.50% RBI subsidy. So net cost in Rupees

7.50%. USD 3m LIBOR 4.35% plus bank margin 0.75% (max. as per

RBI directive but almost 1%), plus 3m cover cost 0.70%. So net cost in

USD 5.80%. Similar would be the cost if export finance is availed in the

other major currencies


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FOREIGN EXCHANGE RISK

FX Risk pertains to the risk of adverse movement in exchange rates:

On Exports

On Imports

On Foreign Currency Borrowings, Installments Payments and

Repayments

The FX risk arises primarily due to:

Developments in overseas markets

Central Bank Intervention

Activities of major market players

Political Turmoil

Economic Developments

Lack of depth or liquidity in the market

Non - availability of enough hedging tools

Development in other markets such as - domestic and overseas stock

markets, turmoil in other currencies, commodities markets, oil prices

etc.

The RBI recognizing the financial risks associated with international trade, has

laid down several Directives and Rules in the Exchange Control Manual. We

are primarily concerned with the directives, rules and guidelines associated

with the management of Foreign Exchange and Interest Rate Risks.

Imports

The RBI permits cover of the FX risks on imports as soon as the import L/C is

opened or as soon as a confirmed order is placed. When the documents

under the L/C are received - the L/C opening bank is due to make payment to

the exporter. This is done by debit to the importer's domestic account -

meaning the FX risk terminates. The bank debits the importer's rupee account

and pays the exporter (or his bank) in foreign currency. An importer has the


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time from opening of the L/C to date of receipt of the documents to manage

the foreign currency exposure. A 10 day grace period is normally permitted by

the RBI to the customers to pay for imports.

Exports

The FX risk on exports can be covered immediately on receipt of an export

order (or L/C). The RBI also stipulates that FX realizations should be

converted into rupees immediately on negotiation of documents. This implies

that the FX exposure on exports can be managed only between the times an

order is received to the date of shipment. Commercial banks are allowed to

grant 10 days grace for receipts of export proceeds beyond which

concessional rate finance is not extended

Category Risk Commencement/Start of Risk Termination /End of Risk

EXPORTER FC Receipt of Export order or L/C Shipment

IMPORTERFC

Opening of Import L/C or placing

of import orderReceipt of documents

FCBORROWER

FC Utilization or draw-down of loan Final repayment

Example

An exporter in India contracts to sell to a firm in London machinery at a price

of GBP 10,000. Before agreeing to this price, the exporter calculates his cost

of production adds a reasonable amount of profit and satisfies that the

proceeds of GBP 10,000 would cover this amount. He bases his calculations

on the exchange rate prevailing as on the date of his quotation. For example,

if the exchange rate on the date is Rs. 70 per sterling pound, he expects to

receive Rs. 7, 00,000 on executing the contract.

The exchange rate is not stable: it is changing every day. By the time the

exporter executes his contract and his bill is realized, which may be after a

lapse of 3 months or 6 months, the rate of exchange might have turned


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adverse for him. For example, if the rate prevailing on the date the bill is

realized or purchased by his banker is Rs. 65, he would receive only Rs. 6,

50,000 as against his estimate of Rs. 7, 00,000. Thus he may have to bear a

shortfall of Rs. 50,000. True, the rate may turn favorable to him and bring him

unexpected profits. But the fact remains that the amount that he would receive

on execution of the contract remains uncertain.

This uncertainty about the rate that would prevail on a future date is known as

the exchange risk. For the exporter, the exchange risk is that the foreign

currency in which the transaction is designated may depreciate in future and

may bring less than the expected realization in local currency terms.

The importer too faces exchange risk when the transaction is designated in a

foreign currency. The risk is that the foreign currency may appreciate in value

and he may be compelled to pay in local currency an amount higher than that

was originally contemplated. Importers generally make arrangements for

loans for payment for the imports. If the foreign currency appreciates

subsequent to the arrangement of the loan, the importer may find that the

resources are not sufficient to meet the importer bill putting him in a difficult

situation.

FOREX Risk Management

Foreign Exchange dealing is a business that one gets involved in, primarily to

obtain protection against adverse rate movements on their core international

business. But, as we have seen earlier, it provides plenty of trading

opportunities as well.

Foreign Exchange dealing is essentially a risk reward business where profit

potential is substantial but it is extremely risky too.

It is in this context that it is absolutely vital that controls are in place which

would enable the department to maintain a check on losses and shocks.

FX business has the certain peculiarities that make it a very risky business.These would include:


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1. FX deals are across country boarders and therefore, often foreign

currency prices are subject to controls and restrictions imposed by

foreign authorities. Needless to say, these controls and restrictions are

invariably dictated by their own domestic factors and economy.

2. FX deals involve two currencies and therefore, rates ate influenced by

domestic as well as international factors.

3. The FX market is a 24 hour global market and overseas

developments can affect rates significantly.

4. The FX market has great depth and numerous players shifting vast

sums of money. FX rates therefore can move considerably, especially

when speculation against a currency rises.

5. FX markets are characterized by advanced technology,

communications and speed. Decision making has to be instantaneous.

With the growth in the Indian FX markets a lot of the features and

characteristics of the global FX markets are present in our very midst.

Indian banks get involved in FX market with a view to generate trading

income.

With the RBI guidelines loosening its controls, granting greater operational

and trading freedom, more and more corporate are getting involved in FX

markets with a view to generating trading income.

With time, as the Indian Rupee gets fully convertible and as the Indian FX

markets get fully integrated with global markets the risks will be more

pronounced in our own exchange market.

It is, therefore, imperative to get the right controls in place prior to any

involvement in FX markets.


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RISK MANAGEMENTTOOLS

FORWARD CONTRACT CURRENCY OPTIONS

1. Forward exchange contract

Forward Exchange Contract is a device which can afford adequate protection

to an importer or an exporter against exchange risk.

Under a forward exchange contract a banker and a customer or another

banker enter into a contract to buy or sell a fixed amount of foreign currency

on a specified future date at a predetermined rate of exchange.

Our exporter, for instance, instead of groping in the dark or making a wild

guess about what the future rate would be, enters into a contract with his

banker immediately. He agrees to sell foreign exchange of specified amount

and currency at a specified future date. The banker on his part agrees to buy

this at a specified rate of exchange. The exporter is thus assured of his price

in local currency. For example, the exporter may into a forward contract with

the bank for 3 months delivery at Rs. 49.50. This rate, as on the date of

contract, is known as 3 month forward rate. When the exporter submits his bill

under the contract, the banker would purchase it at the rate of Rs. 49.50

irrespective of the spot rate then prevailing.

CURRENCY FUTURES


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Fixed and Option Forward Contract

The forward contract under which the delivery of foreign exchange should

take place on a specified future date is known as Fixed Forward Contract.

For instance, if on 5thmarch a customer enters into 3 months forward contract

with his bank to sell GBP 10, 000, it means the customer would be presenting

a bill or any other instrument on 7th June to the bank for GBP 10,000. he

cannot deliver foreign exchange prior to or later than the determined date.

Forward contract is a device through which the customer tries to cover the

exchange risk. The purpose will be defeated if he is unable to deliver foreign

exchange exactly on the due date.

With a view to eliminating the difficulty in fixing the exact date for delivery of

foreign exchange, the customer may be given a choice of delivering the

foreign exchange during a given period of days.

An arrangement whereby the customer can sell or but from the bank foreign

exchange on any day during a given period of time at a predetermined rate of

exchange is known as Time Option Forward contract.

The rate at which the deal takes place is the option forward rate. For example,

on 15thSeptember a customer enters into two months forward sale contract

with the bank with option over November. It means the customer can sell

foreign exchange to the bank on any day between 1st November and 30th

November. The period from 1st to 30th November is known as the Option

Period


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Booking of forward contracts

The steps involved in booking and utilization of a forward contract may be

summarized as under:

Step 1: The transaction of booking of forward contract is initiated with

the customer enquiring of his bank the rate at which the required

foreign currency is available. Before quoting a rate the bank

should get details about (i) the currency, (ii) the period of

forward cover, including the particulars of option, and (iii) the

nature and tenor of the instrument.

Step 2: The branch may not be fed with forward rates of all currencies

by the Dealing Room. Even for major currencies forwards rates

for standard delivery period may only be available at the branch.

If the rate for the currency and/or delivery period is not available,

the branch should contact the Dealing Room over phone or telex

and obtain rate.

Step 3: If the rate quoted by the bank is acceptable to the customer, he

is required to submit an application to the bank along with

documentary evidence to support the application, such as the

sale contract.

Step 4: After verification of the application and the documentary

evidences submitted, the bank prepares a Forward Exchange

Contract.


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2. Currency Options

DEFINITION

An option is a unique financial instrument or contract that confers upon

the holder or the buyer thereof, the right but not an obligation to buy or

sell an underlying asset, at a specified price, on or up to a specified

date. In short, the option buyer can simply let the right lapse by not

exercising it. On the other hand, if the option buyer chooses to exercise

the right, the seller of the option has an obligation to perform the

contract according to the terms agreed.

Participants in the Options Market

There are four types of participants in options markets depending on the

position they take:

1. Buyer of call

2. seller of call

3. buyer of put

4. seller of put

People who buy options are called holders and those who sell options

are called writers; furthermore, buyers are said to have long positions,

and sellers are said to have short positions.

Here is the important distinction between buyers and sellers:

Call holders and put holders (buyers) are not obligated to buy or

sell. They have the choice to exercise their rights if they choose.

Callwritersand put writers (sellers), however, are obligated to

buy or sell. This means that a seller may be required to make

good on a promise to buy or sell.

OPTIONS TERMINOLOGY
http://www.investopedia.com/terms/w/writer.asphttp://www.investopedia.com/terms/w/writer.asphttp://www.investopedia.com/terms/w/writer.asphttp://www.investopedia.com/terms/w/writer.asp


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Call Option:

A call option gives the option buyer the right to buy one currency X

against another Y at a stated price on or before a stated date.

Put Option:

A put option gives the option buyer the right to sell one currency X

against another currency Y at a stated price on or before a stated date.

In foreign exchange transactions one currency is bought by selling

another currency. Thus if we consider the EUR/USD currency pair, a

call option on the euro is no different from a put option on the dollar.

Similarly, a put option on the euro is nothing but a call option on the

dollar.

Strike Price:

This is the price specified in the option contract at which the option

buyer can buy or sell currency X against currency Y or for instance the

euro against the dollar.

Maturity Date:

The date on which the option expires.

American Option:

A call or put option that can be exercised by the buyer on any businessday up to and including the maturity date.

European Option:

A call or put option that can be exercised only on the maturity date.

Premium (Option Price or Option Value):


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The upfront fee that option writer or seller charges the buyer for giving

the latter the right inherent in the option. If the option lapses

unexercised, the buyer loses this amount. This premium can be split

into 2 parts: intrinsic value and time value.

Premium = Intrinsic value + Time value.

Intrinsic value is the amount an option would be worth was it to be

exercised immediately. For instance, if an American call option on EUR

has a strike price of $0.85 and the current spot EUR/USD rate is say

$0.88, the intrinsic value is $0.03 per euro. European options can be

exercised only at maturity. Even so, they can have intrinsic value.European call options will have intrinsic value if the forward rate

applicable for the maturity date exceeds the strike price.

An option with an intrinsic value is called an in-the-money option. An

American/European option is said to be at-the-money if the strike price

equals the spot price/maturity forward price. Lastly,

American/European call options are said to be out-of-the-money if

strike price exceeds the spot price/maturity forward price.

American/European put options are said to be out-of-the-money if the

strike price is less than the spot price/maturity forward price.

An option can have time valueonly if it has some time remaining to

expiry. Time value depends on the chances of the option gaining in

value before expiry. At-the-money and out-of-the-money options have

no intrinsic value and can have only time value.

The time value of a currency option thus depends upon a number of

factors such as the spot price, strike price, time to maturity, volatility of

the market price, domestic interest rate and the foreign interest rate.

Two primary factors affect the time value:


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1. The length of time remaining until expiration.

2. The volatilityof the underlying futures price.

Other factors such as underlying futures price, strike price and general

interest levels in the economy will also influence the option premiums.

Usually decreases with length of time until expiration, but does

increase as price volatility of the underlying futures contract increases.

All else remaining equal, the more time an option has until expiration,

the higher its premium because it has more time to increase in value.

But the options time value will erode much rapidly as the option

approaches expiration. An option value at the expiration will be equal to

its intrinsic value the amount by which it is in the money. This is why

options are sometimes described as decaying assets.

In-the-Money (ITM) options have intrinsic value where as Out-of the-

Money (OTM) options have no intrinsic value. They only have time

value left in the premiums.

What is meant by ITM and OTM? Let us know about these.

An option whose strike price is roughly the same as the underlying

futures price is said to be At-the-Money, while an option that would

result in a loss if exercised is said to be Out-of the-Money. An option

that would result in a profit if exercised is said to be In-the-Money.

A call option is said to be:

In-the-Money (ITM), if Strike price is less than Futures price

At-the-Money (ATM) If Strike price equal to Futures price.

Out-of-the-Money (OTM) If Strike price greater than Futures

price.


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Comparison of Forward Contract and Currency Options

Importer

An Importer has the risk of FC appreciating. To hedge this risk he can eitherbuy FC forward or buy a Call Option. If on the expiry date, FC has

appreciated, he would exercise the option. If FC has depreciated, he would let

the contract lapse

An example of Strategy for Importers

An Importer has a payable after 3 months and has the risk of FC

appreciating

To cover this risk he has two choices

Buy currency forward

Buy a Call Option for the forward date

Suppose Current USD/INR Spot Rate is 45.98-46.00 and 3 months

Premium is 13-15. If he decides to cover the forward his cost is 46.00 +

0.15 = 46.15

If he decides to buy a Call at a Strike Price of 46.15 and if he has to pay

Option Premium of say 25 paisa, his all-in cost would then come to

46.40

Where an importer covers the forward his risk is protected as the cover

rate is fixed

Market rate on the forward date could be 46.15, higher or lower

He would have to settle the contract irrespective of what the market rate

is. If market rate is lower than the cover rate the importer has an

opportunity cost. Unfortunately a forward contract does not provide any

flexibility in such a case

But a Call Option could provide the answer

Let us understand one thing an option contract provides protection

against the unexpected.

And the unexpected for an importer is a fall in FC value

Given the volatility that we have seen in currency markets, it is

impossible to forecast rates with any degree of certainty


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On a positive note, volatility in markets offer opportunities which can be

exploited to reduce cost of hedging

When an importer buys a Call, he gets protection against appreciation in

FC. But what if FC falls? Moreover all of us want to reduce costs. So how

can we go about tackling these dual tasks, of a falling FC and cost

reduction?

Let us take three scenarios: Foreign Currency rises, remains same and

falls

Suppose FC rises above 46.15 before the expiry date.

Though the Call Option becomes In-the-Money no action need to be

taken because risk is FC may continue to rise further or remain above

the Strike Price till expiry.

Call Options provide protection in this very situation

If FC remains same at 46.15 then no point in doing anything.

But what if FC depreciates to below the strike price?

If USD/INR drops to say 45.50 before expiry. Cover the forward and

leave the Option open till expiry. This would help recover all of the

premium and more.

Later, on expiry, to exercise or lapse the Option would depend on the

market rate prevailing then

But if the market moves up before expiry but after doing the forward you

get an opportunity to reduce cost

If USD/INR moves to above 46.15 (say 46.50) liquidating the option

before expiry results in a profit (cost reduction)


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Exporter

An Exporter has the risk of FC depreciating. He can either Sell FC forward or

buy a Put Option to cover this risk. If on the expiry date, FC has depreciated,

he would exercise the option. However if FC has appreciated, he would let the

contract lapse

An example of Strategy for Exporters

An exporter has a receivable say after 3 months and has the risk of FC

depreciating

To cover this risk he has two choices

Sell currency forward

Buy a Put Option for the forward date

If he decides to cover the forward rate is 45.98 + 0.13 = 46.11

If he buys a Put at 46.11 and if he has to pay Option Premium of 25

paisa, his all-in rate would then come to 46.36

Where an exporter covers the forward his risk is protected as the cover

rate is fixed

Market rate on the forward date could be 46.11, higher or lower

He would have to settle the contract irrespective of what the market rate

is. If market rate is higher than the cover rate the exporter has an

opportunity cost.

Unfortunately a forward contract does not provide any flexibility in such a

case

But a Put Option could provide the answer

The unexpected in this case is a rise in FC value

When an exporter buys a Put, he gets protection against depreciation in

FC. But what if FC rises? Moreover every exporter wants to maximize his

return.

So how can we go about tackling these dual tasks, of a rising FC and

ensuring maximum return?

Let us take three scenarios: FC falls, remains same and rises

Suppose FC falls below 46.11 before the expiry date.


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Though the Put Option becomes In-the-Money no action need to be

taken because risk is FC may continue to fall further or remain below the

Strike Price till expiry.

Put Options provide protection in this very situation. If FC remains stable

at 46.11 then no point in doing anything. But what if FC goes above the

strike price?

If USD/INR rises to say 46.50 before expiry. Cover the forward and leave

the Option open till expiry. This would help recover at least some of the

premium

Later, on expiry, to exercise or lapse the Option would depend on the

market rate prevailing then

But if the market goes down before expiry but after doing the forward you

get an opportunity to earn out of the option

If USD/INR moves below 46.11 (say 45.85) liquidating the option before

expiry would be beneficial


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INDIAN Options market

What are available in India are OTC Options contracts only. There is no

exchange where Rupee options are quoted. The market for rupee options

is thin and prices tend to vary widely. Some of the more aggressive banks

market exotic options which do not involve any premium payout. These

have knock-in or knock-out rates which increase the exposure in the event

of it going wrong. This increases risks substantially going against the

very essence of options being a No-Risk product

Look at Options as Insurance, simply because an Option Contract is

designed to provide protection. As in any insurance policy, whose aim is to

obtain protection, an option too, is meant to provide protection to the buyer

And protection at no cost, as a concept, is inherently flawed. A plain

vanilla option is one that provides protection at a price. Such a contract

has no hidden conditions and no risk. Once you buy a plain vanilla option

you obtain protection from any and all future risks. Besides you have

unlimited profit potential. For such a product (facility) there is a price to be

paid, i.e. the Premium. Surely one needs to weigh the risk versus the cost

of protection. As in any insurance plan, consider the risk that you want

protected against cost of obtaining protection. If it makes sense, go ahead

and get the protection have unlimited profit potential. When the risk is high,

as we have seen in currency markets, we need to take steps to protect our

margins. And option premium, we believe, is a small price to pay in these

volatile markets. While a mix of options and forwards could provide a

good hedge, trading strategies are possible in options as well. Indian

corporate are skeptical of Options, the way they exist at the moment,

particularly the so called zero cost ones. Banks appear to be charging

exorbitantly high premium, Market is thin and getting comparative prices is

difficult. Banks do not quote two-way prices making their quotes biased

and unprofessional.


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Types of options

Mainly three types of options are in use:

a. Purchased Plain Vanilla Option Contracts

b. Range Forward (Zero cost) Option

c. Exotic Option

I. A Purchased Plain Vanilla Option Contract

A Purchased Foreign Currency Option Contract is a transaction which gives

the buyer (corporate) of the option contract the right but not the obligation to

settle the contact at a predetermined price (strike price) for a predetermined

maturity and amount. A CALL option gives the buyer the right but not the

obligation to buy the base currency and a PUT option give the buyer the right

but not the obligation to sell the base currency. The authorized dealer

(writer/seller of the option contract) charges an up front premium for the

transaction.

Risks

Premium paid has built in margins of Bank dealers and is not

transparent

European Options cannot be exercised before maturity


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Inputs:

PurchasedPlain

Vanilla

Option

Contract

Exposure type

Business Unit Name

Underlying Transaction

Details

Currency

Amount

Bank Details

Process chart - Purchased Plain Vanilla Option Contracts

Outputs:

Best negotiated

Option Premium

paid

Bank advice

Deal Slip

Confirmation letter to

Bank


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Work out CALL/PUT option strike price, Amount, maturity and Option Typefor the identified Currency pair.

Consult REUTERS/Bloomberg for the given structure

Calculate premium amount payable using Option Premium Calculator

Obtain quotes for premium for required structure from at least TWO BANKSand verify with own calculations

Select authorized Bank where the premium offered is lower

Call the FX Desk of the selected Bank, ask Dealers name

Mention purchase of CALL/PUT option with structure details and negotiatepremium percentage %

Confirm deal

Give the underlying contract details.Confirm American / European option, CALL/PUT, currency Pair, maturity,

strike price. Premium to be paid in INR


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II. Range Forward (zero cost) Option Contracts

A range forward deal involves the simultaneous purchase and sale of call and

put options, for the same principal amount and period, but at different strike

prices. Here the corporate gives up some of the profit potential in return for a

reduced premium liability. A zero cost range forwards is a particular type of

range forward where the strike prices for the call and put options are chosen

in such a manner that there is no premium payable i.e. the premium payable

for the options bought are exactly offset by the premium to be received on

account of the options sold.

Risks

Valuation of option contract is difficult.

Premium paid has built in margins of Bank dealers and is not

transparent

European options cannot be exercised before maturity

Range

Forward

(Zero Cost)

Options

Contract

Outputs:Inputs: Spot price risk hedged

for short maturity Premium to be paid

on purchased option Payment of premium

to Bank (if any) Premium to be

received on soldoption Limited FX Desk profit

over and abovepremium paid (if any),when strike price isnot exercised

Range of prices forexercising strikeprice


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Example Transaction

Underlying exposure:

Imports in Japanese Yen (purchase order amount = 29,250,000)

1 month Forward USD / JPY = 117.00

corporate FX desk buys USD 2,50,000 ATM European Call option on

Japanese Yen for 1 month at strike price of USD / JPY = 117.00, and pays a

premium of 2% (234 pips).

corporate also writes (sells) a USD 2,50,000 OTM Put option on the Japanese

Yen for the identical maturity to the counter party at a strike price of 120.00

and receives a premium of 1.5% (180 pips) from the counter party.

(Assumptions Spot USD / INR = 47)

Net premium paid to the counter party = 234 180

= 54 / 100pips (47 / 117) 250000

= INR 54, 234 /-

USD / JPY USD / JPY USD / JPY USD / JPY= 110 = 117 = 120 = 125

Counter partys profit profile

Corporate profit profile

Corporate will exercise its strike price at 117.00 if the USD / JPY exchange

rate is below 117 on maturity.

Counter party will exercise its strike price at 120.00 if the USD / JPY

exchange rate is above 120 on maturity.

118


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Spot rate on Option

Expiry DateHas the hedge worked?

US

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