Forex n Risk Mgt

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A

Comprehensive Project Report

On

Forex and Risk Management

At

VIZAG STEEL PLANT

Prepared by

PARIKH DEEPAL A.

Guided by

Mr. Alpesh Shah

Mrs. Namrata Mehta

MBA IV Semester :

Academic Year : 2008-'09

Roll No. : _33 (of 4th sem.)

Seat No. : _____

College : Shree H. N. Shukla College

of Management Studies

Submitted to : Saurashtra University


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Declaration

I undersigned Deepal A. Parikh, the student of MBA,

H.N.SHUKLA COLLEGE OF MANAGEMENT STUDIES,

Rajkot(Saurashtra University), here by declare that the project work

presented here is my own work and has been carried out under the

supervision of Prof. Alpesh Shah and Prof. Namrata Mehta of our

College.

This report has not been previously submitted to any other

university for any other examination.

Place: Rajkot Deepal A. Parikh

Date : Signature


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Preface

The trend towards liberalization of the economy and growing integration

of global financial markets is irreversible. The speed of innovation has

accelerated the pace of reforms and the new technology demands almost instant

responses. The new developments, in the coming years of globalization in India

will bring into sharp focus the role of exchange rates and interest rates in

business decision.

As India is becoming integrated part of the world, trade with world will

increase. The foreign exchange and risk management will required to manage

professionally.

Steel comprises one of the most important inputs in all sectors of

economy. Visakhapatnam Steel Plant is a multi-product steel-manufacturing

unit. The Research involves the study of both foreign exchange and risk

management. Every organization exchange policies and risk analysis for

evaluation of the performances of business. For the achievement, Foreign

exchange and risk management is the major and important tool of effective

financial management.


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Acknowledgement

Learning and acquiring knowledge has no leaps and bounds. It is one

resource that never gets exhausted, the more you preach, the better it gets and the

more it lives down through ages. From the day since man set his foot on earth,

learning process had began and is still evolving making life happier and

memorable. One can only lead a person to things he needs to know, but never can

teach him how to learn. Experience through rough and new paths, failures and

hardship makes a man perfect.

I will remain indebted to Mr. Alpesh Shah and Mrs. Namrata Mehta

(Faculty, HNS Rajkot), my project guide for his invaluable ideas and assistance,

which enable me, negotiate every hurdle that I encountered during the project

work.

I am also thankful to Mr. Navneet Thakrar Manager of SBI, Porbandar

without whose support I would not have been in a position to carry out the

project such successfully.

Last but not the least; I would like to express my gratitude to my colleagues and

friends for their moral support and valuable inputs for my project.

Deepal A. Parikh

H.N.S.


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INDEX

Chapter No. Particular Page No.

Declaration II

Preface III

Acknowledgement IV

1. Industry Overview 7.

2. Company Profile

Background of VSP

Hallmark of VSP

Future Plans

SWOT Analysis

13.

13.

17.

20.

22.

3. Research Methodology

Relevance of the Study

Objectives of the Study

Research Design

Scope of the Study

Data Collection

24.

25.

25.

26.

27.

27.

6. Theoretical Aspects of the study

Forex

Financial Arrangement of VSP

Significance of Risk

Financial Risk & Integrated Risk Management

System

Hedging Mechanism

28.

29.

44.

52.

56.

61.


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Currency Swaps

Letter of Credit

67.

74.

7. Analysis & Interpretation

Technical Analysis

78.

86.

8. Summary & Findings 100.

10. Suggestion & Conclusion 103.

11. Bibliography 107.


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INDUSTRY OVERVIEW

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Industry Overview

The base of the economic stability of nation depends on the strong

industrial it enjoys. The Indian economy is on a new growth path with buoyancyin capital markets, positive growth in GDP, strong Forex reserves and a

remarkable growth in industrial sector. Industry output has grown by 8.2% in

2004-05 compared to 7.0% growth in 2003-04. Manufacturing industry has

grown at 10% (till Apr 05) as against 8.8% growth in Apr 04. With brisk

demand for steel, textiles, non-ferrous metals, gem & jewellary. The future

prospects of Indian industrial sector as a whole looks promising as outlays onmega projects in steel, power & oil natural gas sectors are contemplated in

unprecedented manner. India is going to be a base for expansion of capacity of

many industries by many multinationals and others with lower costs & higher

scope for increasing exports to neighboring countries.

The following literature looks into the global & Indian steel sector

scenario in brief.

Global Scenario :

Global steel demand is on rise on the back of accelerated infrastructure

activity in China, booming housing industry & recovering auto industry in U.S,

buoyant housing & white good industry in Europe. Reconstruction work in Iraqis expected to fuel further demand for steel over next 3 years.

At present China is the worlds largest crude steel producer followed by

Japan & U.S.A. while U.S.A is the largest importer of semi finished & finished

steel products, Japan is the largest exporter of the same. However, the world at

large is grappling with over capacity problem.

The reasons for this difficult phase are owned to:

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Demand Supply mismatch due to unfair priced trading regime.

Large gap between installed capacity & effective capacity and effective

capacity & actual production.

Anti-dumping measures taken against CIS, China, Brazil, India & a few

other countries led to distortion in world trade.

Over capacity.

The global steel industry is facing the raw material shortage in wake of Chinas

massive infrastructure building exercise in view of 2008 Beijing

Olympics. The prices may stabilized after the Olympics. A move has

been initiated globally to cut production of steel thereby to control the

declining steel prices. This cut down of capacity is expected to restore

supply demand balance to some extent.

It is projected that China will emerge a net exporter for exports of Semi, long

products & HR wide coils. Imports by U.S may continue with the dollar

losing its shine against major currencies.Global steel industry is presently

poised to reasonable growth, which is reflected in renewed interest shown

by entrepreneurs for investments in the sector. The demand push in

China, India CIS & also in U.S.

Indian steel sector:

Operating performance is a main driver of competitiveness of any company.Based on this parameter Indian steel industry is much below global

standards. Although significant improvement has been observed in

material, energy and manpower productivity, it is not in a position to

compete with steel majors like SCO, CS or NUCOR. India is placed in 8 th

position overall among the steel producing countries in the world.

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The reasons for slow growth in India steel industry are:-

Poor productivity due to small size of plants & policy lapses and poor

investment in technology. Less spending on R & D (less than 1% of revenues) & use of obsolete

technology.

Outdated mining policies.

High transaction costs (nearly 10% of foreign trade).

Costly freight charges.

Cost of capital is 2 times the world average interest rate.

Taxes and levies constitute 30% of final value of steel.

Significant government intervention.

In line with global trend, the Indian steel industry has been passing through

tough conditions. The prices have declined due to over capacity, cheap imports,declining global steel prices and also due to anti dumping duty imposed by USA

on Indian exports. However, the present condition is better compared to last

decade, which saw steel prices at rock bottom levels.

There is a gradual improvement in steel prices owing to-

1. Trade cases & import restrictions by many steel-producing countries.

2. Voluntary production cuts after sharp tall in prices.

3. Continuing strong demand in USA, China.

4. Recovery in Asian Economics.

The consumption of finished carbon steel increased from 14.84 MT in 1991-92

to 33.37 MT in 2005-06. China has been an important export destination for

Indian steel.

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In 2005-06 the production of finished carbon steel & pig iron are as follows.

0

10

20

30

40

2005-2006(million tones)

Pig Iron

Finished CarbonSteel

The share of main producers (SAIL, RINL, TISCO) & secondary producers in

total production of finished carbon steel was 40% & 60% respectively during

the year 2005-06.

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Category

2005-2006

(million tones)

Pig Iron 3.171

Finished Carbon

Steel 38.385


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The total steel imports are estimated to be 2.050 MT while exports stands at

4.375 MT in 2005-06.

Domestic demand is expected to steadily rise from the current level of 34

million tones of apparent to the projected level of 60 MT by 2011-12. This

makes it necessary to have fresh capacity additions in steel. This in turn is to be

supported by adequate sourcing of metallic and infrastructure growth including

port development to support the transportation needs of output to cater both

domestic & global demands.

The industry now looks ahead with anew resolve & determination. Reaping the

benefits of globalized markets calls for utmost vigilance from all stakeholders

producers, consumers & state. The industry should capitalize the opportunities

and mitigate the dangers of synchronized global trends.

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COMPANY PROFILE

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PROFILE OF VSP

INTRODUCTION:

Steel occupies the foremost place among the materials in use today and

pervades all walks of life. All key discoveries of human genius, for

instance, Steam Engine, Railway, means of Communication and

Connection, Automobile, Aero Plane and Computers are in one way or

other, fastened together with Steel and its sagacious and Multifaceted

applications.

Steel is versatile material with multitude of useful properties, making

it indispensable for furthering and achieving continual growth of

economy be it Construction, manufacturing, infrastructure or

consumables. The level of steel consumption has long been regarded as

an index of industrialization and economic maturity attained by a country.

Keeping in view of the importance of steel, the following integrated

steel plants with foreign collaborations were set up in public sector in

post independence era

Background of Visakhapatnam Steel Plant:

To meet growing domestic needs of steel, Government of India decided to set

up an Integrated Steel Plant at Visakhapatnam. An agreement was signed

with erstwhile USSR in 1979 for co-operation in setting up 3.4 MT

integrated steel plant at Visakhapatnam.

The Company started its commercial production in 1990-91 and its financial

results in Table

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FY Gross Sales Operating Profit Interest Depreciation Net Profit

90-91 245 -88 192 197 -478

91-92 772 -101 437 449 -987

92-93 1185 -31 198 340 -568

93-94 1751 114 346 340 -573

94-95 2209 416 366 415 -364

95-96 3039 633 407 430 -204

96-97 3135 606 430 422 -246

97-98 3071 460 198 439 -177

98-99 2761 15 361 111 -457

99-00 2973 252 382 432 -562

00-01 3436 504 351 445 -291

01-02 4081 690 290 475 -75

02-03 5058 1162 187 455 521

03-04 6169 2053 49 457 1547

04-05 8181 3271 11 1006 2254

05-06 8482 2336 31 416 1890

06-07 9800 2950 40 520 2100

07-08 1200 2600 60 640 2450

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The Company started its commercial production in 1990-91 and its

financial results in Table given above

It can be seen from the above table during the year 2002-03, thecompany turned around by earning a net profit of Rs. 521 Crores. In the

same year, it bagged the PRIME MINISTER TROPHY for its excellent

performance in the Steel Industry. In September 2003, RINL became a

DEBT FREE COMPANY.

Technology:

VSP was equipped with state of the art technology of steel making,

large scale computerization and automation was incorporated in the plant

to achieve International Level of Efficiency and Productivity, the

organizational manpower has been rationalized.

Major Sources of Inputs:

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HALLMARK OF VIZAG STEEL AS AN ORGANISATION

Today, VSP is moving forward with aura of confidence and with pride

amongst its employees who are determined to give their best for the

company to enable it to reach new heights in organizational excellence.

At the same time, no single advantage accruing from a knowledge

society if found wanting by the neighborhood community with the

growth & development of a phenomenon called VIZAG STEEL existing

so close to its proximity. Futuristic enterprises, academic activity,

planned & progressive residential localities but few of the plentiful ripple

effects of this transformation and each one of us take immense pride touphold the philosophy of mutual (i.e., individual and societal) progress.

As a NET POSITIVE COMPANY in January, 2006 by wiping out all

its Accumulated losses during 2005-06.

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Raw Material Source

Iron Ore lumps and fines Bailadilla, MP

BF Limestone Jaggayyapeta, AP

BF Dolomite Madharam, Andhra Pradesh

SMS Dolomite Madharam, Andhra Pradesh

Manganese Ore Chipurupalli, Andhra Pradesh

Boiler Coal Talcher, Orissa

Coking Coal Australia

Medium Coking coal (MCC) Gidi/swang/rajarappa/kargali


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Statistical information:-

COMMERCIAL PERFORMANCE (Rupees in Crores)

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Year Sales Turnover Domestic Sales Exports

2000-01 3436 3122 322

2001-02 4081 3710 371

2002-03 5059 4433 626

2003-04 6174 5406 768

2004-05 8181 7933 248

2005-06 8469 8026 443

2006-07 9126 8702 425


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FINANCIAL PERFORMANCE (RUPEES IN CRORES)

Year Gross Margin Cash Profit Net profit

2000-01 504 153 (-) 291

2001-02 690 400 (-) 75

2002-03 1049 915 521

2003-04 2073 2024 1547

2004-05 3271 3260 2008

2005-06 2383 2355 1251

2006-07 3672 2600 1806

2007-08 3960 2970 2450

FUTURE PLANS:-

VISION

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To be a continuously growing world-class company.

Harness our growth potential & sustain profitable growth

Deliver high quality and cost competitive products and be the first choice

of customers

Create an inspiring work environment to unleash the creative energy of

people

Achieve excellence in enterprise management

Be a respected corporate citizen, ensure clean and green environment and

develop vibrant communities around us

MISSION:-

To attain 16 million ton liquid steel capacity through technological up

gradation, operational efficiency and expansion to produce steel at

international standards of cost and quality, and to meet the aspirations of

stakeholders.

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Objectives:-

Expand plant capacity to

6.3 Mt by 2008-09, 8.5 Mt by 2010-11, 13.0 Mt by 2014-15

With the mission to expand further in subsequent phases as per the

Corporate Plan.

Be amongst the top five lowest cost liquid steel producers in the world by

09-10

Achieve higher levels of customer satisfaction than competitors

Vibrant work culture in the organization

Be recognized as a excellent business organization by 2008-09

Be proactive in conserving environment, maintaining high levels of safety

and addressing social concerns

CORE VALUES:-

Commitment

Customer Satisfaction

Continuous improvement

Concern for Environment

Creativity & Innovation

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SWOT ANALYSIS:

SWOT analysis of VSP depicts the strengths of VSP, weakness that are

to be avoided, opportunities that should be banked, and threats that should be

faced & yet survive in the business.

Strengths & Weaknesses:

Strengths Weaknesses

Availability of funds for

investment and redemption of

preference equity(Rs. 7686 Cr. As

on 31.03.08)

Availability of land and

infrastructure facilities for

expansion unto 16 MT

Image as value for money

supplier

Superior basic steel making

technology

Strong committed workforce

Lack of inhouse or captive raw

materials mines resulting in high

cost of raw materials

Capital repairs, upgradation and

modernization due for major

facilities

Lack of higher levels of

automation

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Opportunities & Threats:

Opportunities Threats

High to moderate rates of

economic growth projected and

strong demand forecast for steel

Commissioning of Gangavaram

Port will enhance port basedadvantage for VSP

Shift of value chain towards raw

materials rising input costs

Massive expansion plans of

existing competitors

Entry of international players

Dependency on single supplier for

sourcing iron ore

Heavy order bookings of

equipment suppliers thus adverse

impact on expansion plans high

costs and delays.

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RESEARCH METHODOLOGY

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Research Methodology

Relevance of the Study

The level of steel consumptions has long been regarded as an index of

industrialization and economic maturity attained by country. Keeping in view

the importance of steel, the integrated steel plants with foreign collaborations

were set up in the public sector in the post-independence era.

Efficient management of financial resources and deliberate analysis of

financial results are pre requisite for success of an enterprise. For the

achievement of that, Foreign exchange and risk management are the major and

important tool of effective financial management. Every organization exchange

policies and risk analysis for evaluation of the performances of business.

Objective of the Study

The complexity of experiencing foreign exchange exposure in steel

industry and hedging of associated risks has been more challenging as never

before. The objectives of taking up the subject for the project work at VIZAG

STEEL are as follows:

To understand the nature of foreign exchange transactions undertaken

in VIZAG STEEL .

To ascertain the requirement of imported raw materials, spares,

equipments etc for the steel plant and payments.

To ascertain the value of export, other earnings in foreign exchange

and realization.

To assess the foreign exchange payments towards procurement of

capital equipments, technological know-how, services of foreign

experts etc.

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To analyze the risks involved in undertaking the foreign exchange

transactions in current scenario.

To understand the risk philosophy, risk policy for foreign exchange

transactions and perceptions about the existing risks at VIZAG

STEEL.

To evaluate the risk management practices adopted at VIZAG STEEL

to mitigate foreign exchange risks and their effectiveness.

To identify the deficiencies, study the impact and suggest measures to

overcome the same in the current scenario.

Research Design

Research design is the blueprint of the research project. It includes the

different things which are methods, sampling plan, data collection methods. It

provides the guidance as well as information for the study. Research design

has been in Descriptive nature.

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Scope of Research

In order to undertake the study it is essential to understand the operations

of the company associated with the requirements of foreign exchange and the

risk management efforts. It is also pertinent to find out such efforts in other

corporate in steel industry.

The study involves collection of data from secondary sources relating to foreign

exchange requirements on account of import of raw materials, spares,

payment of ocean freight, arrangement of suppliers/ buyers credit/ loans,

payments towards hiring of technological services from foreign experts

etc.. On the other hand the forex realizations from exports have to be

collected to understand the mode of collection of export proceeds, timingand utilization of foreign exchange, parking of funds, if any.

Data Collection

Secondary data:

The secondary data was collected from already published sources such as,

pamphlets of annual reports, Website.

The data collection includes:

Collection of required data from website and annual report of

Visakhapatnam Steel Plant.

Reference from textbooks and journals relating to financial management.

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THEORY ASPECTS OF RESEARCH

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FOREIGN EXCHANGE

Exchangeword was not aware in that age. With the changes in the needs,

human being became lesser self sufficient in meeting the needs and started

seeking other things in return for the available commodities. The Breton Woods

Agreement was initiated in 1944 in an effort to keep cash from draining out.

Thus the marketability and familiarity of a commodity determined its

acceptance and use as means of exchange. Over a period of time, metals in the

form of coins were introduced as medium of exchange.

The modern era of foreign exchange first emerged in 1971 with the

collapse of the Bretton Woods Agreement. These persons enjoyed the trust of

the people and were entrusted with the job of safe keeping of surplus money.

Paper currency with sovereign authentication became the medium exchange and

accepted all over the world. This was a major development and ultimately led to

the spread of banking services. People were confident that they would receive

certain value, on demand, against the paper currency or note they possess.

With the movement of goods and services across the border of countries in

the form of International Trade, the requirement of foreign exchange or

currencies of other countries became essential. The necessity was also felt due

to the reasons like different monetary units of different countries, restrictions

between the countries for export/imports and the national payments, different

legal practices etc.

In India, foreign exchange has been given a statutory definition. Section 2

(b) of foreign exchange regulation ACT, 1973 states: Foreign Exchange means

Foreign currency and includes-

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All deposits, credits and balance payable in any foreign currency and any

draft, travelers cheques, letter of credit and bills of exchange. Expressed

or drawn in India currency but payable in any foreign currency.

Any instrument payable, at the option of draw or holder thereof or any

other party thereto, either in Indian currency or in foreign currency or

partly in one and partly in the other.

Foreign Exchange in the Global Economy:-

The foreign exchange market has been an invisible hand that guides the

sale of goods, services and raw materials on every corner of the globe. The

forex market was created by necessity. Traders, bankers, investors, importers

and exporters recognized the benefits of hedging risk, or speculating for profit.

The fascination with this market comes from its sheer size, complexity and

almost limitless reach of influence.

Inter-bank currency contracts and options, unlike futures contracts, are not

traded on exchanges and are not standardized. Banks and dealers act as

principles in these markets, negotiating each transaction on an individual basis.

Forward "cash" or "spot" trading in currencies is substantially unregulated -

there are no limitations on daily price movements or speculative positions.

ABOUT FOREIGN EXCHANGE MARKET

There is no market place called the foreign exchange market. It is mechanism

through which one countrys currency can be exchange i.e. bought or sold for

the currency of another country. The foreign exchange market does not have

any geographic location.

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Forex Market is stated that it is functioning throughout 24 hours a day. Foreign

exchange market is described as an OTC (over the counter) market as there is

no physical place where the participant meets to execute the deals, as we see in

the case of stock exchange. The largest foreign exchange market is in London,

followed by the New York, Tokyo, Zurich and Frankfurt. The markets are

situated throughout the different time zone of the globe in such a way that one

market is closing the other is beginning its operation.

RBI has granted to various firms and individuals, license to undertake money-

changing business at seas/airport and tourism place of tourist interest in India.

In order to provide facilities to the public and foreigners visiting India, for

exchange of foreign currency into Indian currency and vice-versa. Certain

authorized dealers in foreign exchange (banks) have also been permitted to open

exchange bureaus.

Even among the banks RBI has categorized them as follows:

Branch A They are the branches that have nostro and vostro account.

Branch B The branch that can deal in all other transaction but do not

maintain nostro and vostro a/cs fall under this category.

Branch C - such branches cannot do anything with forex business.

For Indian we can conclude that foreign exchange refers to foreign money,

which includes notes, cheques, bills of exchange, bank balance and deposits in

foreign currencies.

Market size and liquidity:-

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The foreign exchange market is unique because of

Its trading volumes,

The extreme liquidity of the market,

The large number of, and variety of, traders in the market,

Its geographical dispersion,

Its long trading hours: 24 hours a day (except on weekends),

The variety of factors that affect exchange rates.

The low margins of profit compared with other markets of fixed

income (but profits can be high due to very large trading volumes)

Average daily turnover in traditional foreign exchange markets is estimated at

$3.21 trillion. Daily averages in April for different years, in billions of US

dollars, are presented on the chart below:

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This $3.21 trillion in global foreign exchange market "traditional" turnover was

broken down as follows:

$1,005 billion in spot transactions

$362 billion in outright forwards

$1,714 billion in forex swaps

$129 billion estimated gaps in reporting

Exchange-traded forex futures contracts were introduced in 1972 at the ChicagoMercantile Exchange. Forex futures volume has grown rapidly in recent years,

and accounts for about 7% of the total foreign exchange market volume,

according to The Wall Street Journal Europe

Foreign exchange trading increased by 38% between April 2005 and

April 2006 and has more than doubled since 2001. Average daily global

turnover in traditional foreign exchange market transactions totaled $2.7 trillion

in April 2006 according to IFSL estimates based on semi-annual London, New

York, Tokyo and Singapore Foreign Exchange Committee data. This is largely

due to the growing importance of foreign exchange as an asset class and an

increase in fund management assets, particularly of hedge funds and pension

funds.

The biggest geographic trading centre is the UK, primarily London,

increased its share of global turnover in traditional transactions from 31.3% in

April 2004 to 32.4% in April 2006

The ten most active traders account for almost 73% of trading volume,

according to The Wall Street Journal Europe, (2/9/06 p. 20). The bid/ask spread

is the difference between the price at which a bank or market maker will sell

("ask", or "offer") and the price at which a market-maker will buy ("bid") from

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a wholesale customer.

Foreign Exchange Markets scope:-

The forex market dwarfs the combined operations of the New York, London,

and Tokyo futures and stock exchanges. Daily turnover on the spot market is

approximately US$1.5 trillion per day.

Spot transactions and forward outright FX trading takes place in the inter-bank

market. 51% of the market is in spot FX transactions, followed by 32% in

currency swap transactions. Forward outright FX transactions represent another

5% of this daily turnover. Options on inter-bank FX transactions making up

another 8%. Therefore the inter-bank market accounts for 96% of the global

foreign exchange market, with the remaining 4% being divided among all the

global futures exchanges.

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Exchange rate

Exchange rate can be defined as the rate at which one currency is converted into

another currency. For example the Indian Rupees can be exchanged toobtain US dollar. Say one US dollar can be had by paying Rs 44. This

exchange rate can be expressed in the form of either as Direct quote as

USD 1 = INR 44, where the home currency is variable unit or

alternatively, expressed in Indirect quote as INR 1 = USD 0.022727,

where the home currency is taken as 1 unit. The principle adopted in

exchanging the currency in Direct quote is Buy Low & Sell High and

similarly in the Indirect quote isBuy High or Sell Low.

There are two important theories behind determination of exchange rates. They

are as follows:

Purchasing power parity theory.

Balance of payments theory or Demand & Supply theory.

1. PURCHASING POWER PARITY (PPP) THEORY:

According to the purchasing power parity theory, after the First World War, the

rate of exchange between two currencies in the long run will be

determined by their respective purchasing power. It emphasizes that the

rate of exchange between two currencies must and essentially depend

upon the quotient of the internal purchasing power of these currencies.

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In the long run the value is determined by the relative values of two currencies

as indicated by their relative purchasing power over goods and services.

In other words, the rate of exchange tends to rest at a point which

expresses equality between the respective purchasing power of the two

countries. This point is called the parity of purchasing power. The

exchange rate between one country and another is in equilibrium when

the domestic purchasing power at that rate of exchange is equivalent. For

example assume that X commodity in India costs Rs:44/ per Kg and the

same in U.S.A costs USD 1, then the exchange rate under purchase

parity would be USD 1= INR 44. A change in the purchasing power of

currencies will be reflected in their exchange rates. The index number of

prices may be used to determine the purchasing power parity. If there is a

change in the new equilibrium, the rate of exchange can be found out by

the following formulae :

ER = Er ( Pd/Pf)

Where ER = Equilibrium exchange rate

Er = Exchange rate in the reference period

Pd = Domestic price index

Pf = Foreign countrys price index.

2. BALANCE OF PAYMENTS THEORY:-

The Balance of Payments theory also known as the Demand and supply theory

advocates that the foreign exchange rate, under free market conditions, is

determined by demand and supply of currency in the foreign exchange market.

The value of currency appreciates when the demand for it increases and

depreciates when the demand falls, in relation to its supply in the foreign

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exchange market. The extent of the demand and supply of a countrys currency

in foreign exchange market depends on the balance of payment position. The

balance of payments theory provides a fairly satisfactory explanation of the

determination of rate of exchange.

Determinants of Exchange rate:-

a) Balance of payments (Bop) : Balance of payment represents the demand for

and supply of foreign exchange. Exchange rate (ER) is influenced by the change

in exports and imports of a country. If exports of a country exceed its imports,

the demand for home currency increases due to greater flow of foreign

exchange so that the ER moves in favor of home currency and it appreciates. On

the other hand, if imports are more than exports, the BoP of a country shows

deficit resulting in increase in demand for the foreign currency and the ER

moves against the home currency causing depreciation in the home currency.

b) Interest rates : The movement of foreign exchange is also dependant on the

arbitrage arising out of the interest rates between the domestic currency and

other currencies. The difference in the interest rates lead to currency carry-

trades. Currency carry-trades is a strategy in which an investor sells a certain

currency with a relatively low interest rate and uses the funds to purchase a

different currency yielding a higher interest rate. A trader using this strategy

attempts to capture the difference between the rates - which can often be

substantial, depending on the amount of leverage the investor chooses to use.

c) Inflation: It is the changes in relative price levels of Two countries that cause

changes in the exchange rate. In other words increase in price level reduces the

purchasing power of common man. For example if the whole sale prices in

Britain rises more than the relative price rise in USA, the situation leads to risein the prices of British goods in terms of pounds /dollars in USA. British goods

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will become dearer in the USA, On the other hand, the American goods become

cheaper in Britain causing increase of American exports and increase in

demand for US dollars.

d) Money supply : Volume of money supply also affect the movement of

exchange rate . This includes the purchase and sale of currencies and negotiable

instruments such as bank drafts, letters of credit, Bills of exchange etc.. The

credit availability and fixation of bank rates also influence the exchange rate. If

the money supply increases, it will fuel inflation and the home currency

becomes cheaper vis--vis foreign currency.

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e) National income: The national income also influences the exchange rate.

Higher GDP reflects stronger economy and currency commands a strong

position in the international market. Growth in GDP shows increase in

production, consumption and export of commodities/services thereby

increase in inflow of foreign currencies thereby movement of exchange

rate in favor of home currency.

f) Resources: The availability of natural resources in the country like, mines ,

minerals, natural gases, coastal lines etc helps in improving the national

income and increased participation in the international trade. It is

important to make best use of the available resources in harnessing

countrys growth and improve per capita income.

g) Movement of capital: Short term or long term capital movements of capital

in the form of FII/FDI inflows or outflows also influence the exchange

rate. Foreign Capital-in Flows tend to appreciate the value of the home

currency. The exchange rate will move in favor of the capital-importing

country and against the capital-exporting country.

h) Political factors: Political conditions in the country have a significant

influence on the exchange rate. Political stability, strong and efficient

governance create confidence in the mind of citizens as well as foreigners

to invest their funds in the country in the form of joint ventures,

acquisitions, deposits, equity participation etc.. With the inflow of capital,

the demand for domestic currency rises and the exchange rate moves in

favor of the home currency.

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i) Market forces: Efficient and effective operation of Stock exchanges,

operation in foreign securities, debentures, stocks and shares etc. exert

significant influence on the exchange rate. If the stock exchanges play

conducive role in the sale of securities, debentures, shares etc to foreign

investors, the demand for the domestic currency will rise and the

exchange rate becomes favorable.

j) Speculation: The growth of speculative activities also influence the exchange

rate. Speculation causes short- term movement of funds causing volatility

in the movement of exchange rates. Uncertainty in the global financial

market encourages speculation in foreign exchange. If the speculators

expect a fall in the value of currency in the near future, they will sell to

acquire appreciating currency to exchange later in the financial market.

k) Structural changes: It is another important factor which influences the

exchange rate of the currency. These changes bring a shift in the

consumer demand for commodities. They include technological changes,

innovations, taste, preferences etc. which affect the demand for existing

products and requirement of new products.

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EXCHANGE RATE SYSTEMS

Broadly there are two important exchange rate systems, namely the Fixed

exchange rate system and Flexible exchange rate system. They are

brought out below:

FIXED EXCHANGE RATE

Countries following the Fixed exchange rate (also known as stable rate or

pegged exchange rate) system agree to keep their currencies at a fixed

ratio or pegged rate to a major currency and change their value when theeconomic situation forces them to do so. For example, Chinese Yuan is

pegged to US dollar. Under the gold standard, the values of currencies

were fixed in terms of ounce of gold. With the collapse of the

Brettonwoods System in August 1971, some of the members adopted

floating currency method while others still embraced the fixed exchange

rate system.

FLOATING/FLEXIBLE EXCHANGE RATE

Under the floating exchange rate system, exchange rates are freely

determined in an open market environment based on the supply and demand for

the currencies and there is no intervention from regulatory authority to control

the exchange rate. Whereas under flexible exchange rate system, the exchange

rate is fixed but subject to frequents adjustments depending upon the market

conditions by intervention of regulatory authority. Balance of payment is an

important factor in determining the exchange rate under this system. This

situation makes foreign goods cheaper in terms of the domestic currency and

domestic goods become more expensive in terms of the foreign currency. It

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encourages imports and discourages exports, resulting in the restoration of the

balance of payments equilibrium.

On the other hand, a deficit in the balance of payments will give rise to an

excess supply of the countrys currency and the exchange rate will tend to fall.

If there is deficit in balance of payments, the exchange rate falls and this makes

domestic goods cheaper in terms of the foreign currency and foreign goods

more expensive in terms of the domestic currency. This encourages exports, and

discourages imports and thus establishes the balance of payments equilibrium.

EXTERNAL VALUE OF RUPEE

In the year 1971, USA suspended the convertibility of the US dollar into

gold leading to the collapse of fixed parity system under the Bretton woods

agreement. In view of the uncertainties in the international situation, Indian

Rupee was pegged at 1Re = USD 0.133333. To correct the situation Govt. of

India de-linked Rupee from Pound sterling on 25Th September 1975 and linked

it to an undisclosed basket of currency but pound sterling was retained as the

intervention currency in terms of which the external value of Rupee was fixed.

In the year 1991 Rupee was further devalued by 22pct and dual exchange

rate was introduced. With effect from March 1992, US dollar was adopted as

the intervention currency in place of sterling and Rupee was partially floated.

The external value of the Rupee was made fully independent on market forces

from March 1993 and official rate was abolished.

CONVERTIBILITY OF RUPEE

Convertibility of Rupee refers to its conversion into any foreign

currency as desired by its holder. The currency is considered as fullyconvertible if the holder can convert it into any other currency at rates

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determined by the forces of demand and supply without any intervention from

the government. The convertibility involves two steps like determination of rate

by market forces and the absence of restrictions on the repatriation of the

currency.

Rates as of 2008-06-27 19:09:36 UTC (GMT). Base currency is INR.

Currency Unit INR per Unit Units per INR

======================= ============= =============

USD United States Dollars 42.7800000000 0.0233754091

EUR Euro 67.4783476888 0.0148195686

AUD Australia Dollars 41.0575439811 0.0243560599

JPY Japan Yen 0.4029680400 2.4815863810

INR India Rupees 1.0000000000 1.0000000000

NZD New Zealand Dollars 32.5256614444 0.0307449551

CHF Switzerland Francs 41.9975769690 0.0238108975

ZAR South Africa Rand 5.4229133525 0.1844027251

AFN Afghanistan Afghanis 0.9281686828 1.0773903693

ISK Iceland Kronur 0.5317027942 1.8807499433

ILS Israel New Shekels 12.7229200712 0.0785983088

KES Kenya Shillings 0.6632558140 1.5077138850

NZD New Zealand Dollars 32.5256614444 0.0307449551

NGN Nigeria Nairas 0.3633429591 2.7522206639

NOK Norway Kroner 8.4497234551 0.1183470684

SGD Singapore Dollars 31.3935569102 0.0318536699

KRW South Korea Won 0.0411166674 24.3210372698

SDG Sudan Pounds 20.8109357138 0.0480516597

CHF Switzerland Francs 41.9975769690 0.0238108975

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GBP United Kingdom Pounds 85.2659900992 0.0117280055

Currency remittances are broadly classified into two categories,

I) Current account

ii) Capital account

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Financial Arrangements Of VSP

The capital structure of VSP at the time of completion of the plant was

represented by Share Capital of Rs. 6170.57 crores and external debt (loan

funds) of Rs. 3608.86 crores. With this capital composition, the Debt to Equity

was 0.58 and as of now there is no external debt except cash credit which is

being utilized at the minimum possible levels for the purpose of working capital

requirements. VSP had become debt free company during 2002-03 FY by

paying out entire debt from the internal generations. As on date, the Equity is

Rs. 7827.32 crores and the cash credit is Rs. 88.15 crores as per the balance

sheet of 2005-06 FY. The increase in the Equity is due to conversion of Govt.

loan and its accrued interest into preference share capital.

VSP has got financial arrangements for Working Capital with various

Banks under Multiple Banking Arrangement (MBA). This arrangement

comprises Fund Based and Non-Fund based Working Capital. Fund BasedWorking Capital includes Cash Credit (CC), Working Capital Demand Loan

(WCDL) and Export Packing Credit (EPC) and the Non-Fund based Working

Capital includes Letter of Credit (LC) and Bank Guarantee (BG). VSP is

presently managing with total working capital limits up to Rs. 1801.65 crores as

on 31.03.2006 out of which the fund based limit is Rs. 570.65 crores and non-

fund based limit is Rs. 1231 crores. The Working Capital limits for each

category of basis are as below.

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Working Capital limits in 2006-07

Fund based Rs in Crs

Cash Credit 131.84

Working Capital Demand Loan 263.14

Export Packing Credit 175.67

Sub-Total: 570.65

Non-Fund based

Letter of Credit 1176.00

Bank Guarantee 55.00

Sub-Total: 1231.00

TOTAL 1801.65

EXCHANGE CONTROL

Exchange control refers to the control by the government or centralized

agency of transactions involving foreign exchange. It is one of the important

mechanisms of achieving certain national objectives like improvements in the

balance of payments position, promotion of exports, regulation of essential

imports, conservation of foreign exchange, control of outflow of capital and

maintenance of the external value of the currency etc.

Exchange control in India was introduced in India in 1939 to conserve the

foreign exchange and utilize them for essential purposes. In order to continue

with the control of foreign exchange, Foreign Exchange Regulation Act( FERA)

1947 was enacted. The act was reviewed in 1973 and 1993. Foreign Exchange

Management Act( FEMA) 1999 was enacted. The main objective of FEMA is

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focused on facilitating external trade and payments and for promoting the

orderly development and maintenance of foreign exchange markets in India.

The foreign exchange resources and transactions of the nation are

monitored by the exchange control authority. Central government may from

time to time give Reserve bank such general or specific directions as it thinks fit

and Reserve bank shall comply with such directives. Though the exchange

control regulatory measures are administered by Reserve bank, the foreign

exchange transactions are routed through the persons/agencies authorized by

Reserve bank such as authorized dealers, money changers, offshore banking

unit or any other person .

Objectives of exchange control

The major objectives of exchange control are outlined below :

- Monitoring the transactions distinctly under current and capital account

through the authorized dealers.

- Conservation of foreign exchange to maintain the external value of Rupee

and utilization to meet import requirements.

- Improvement of Balance of payments

- Maintain exchange rate stability and control speculation

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METHODS OF EXCHANGE CONTROL

The various methods of exchange control may be broadly classified into

1) unilateral method and

2) bilateral method.

UNILATERAL METHOD:

Unilateral measures refer to those methods which may be adopted by a

country unilaterally. i.e without any reference to or understanding with other

countries. The unilateral measures are outlined below :

REGULATION OF BANK RATE: A Change in the bank rate is usually

followed by changes in all other rates of interest and affect the flow of

foreign capital. REGULATION OF FOREIGN TRADE: The rate of exchange may be

controlled by regulating the foreign trade of the country. Encouraging the

exports and discouraging the imports.

EXCHANGE RATE PEGGING : Exchange rate pegging refers to the

policy of the government of fixing the exchange rate to specific currency

arbitrarily either below or above the normal market rate.

BILATERAL METHOD:

PRIVATE COMPENSATION AGREEMENT : Under this method, a

firm in one country is required to equalize its exports to the other country.

So that there will be neither a surplus nor a deficit.

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CLEARING AGREEMENT: Under the clearing agreement importers

make payments in domestic currency for clearing the goods. The need for

foreign exchange does not arise except for getting the net balance

between the two countries.

STAND STILL AGREEMENT: The stand still agreement seeks to

provide the debtor country sometime to adjust their position by

preventing the movement of capital out of the country through a

moratorium on the outstanding short term foreign debts.

Foreign exchange regulation and control

The most important concept in the foreign exchange system is the regulation

and control of foreign exchange. Proper management of the foreign exchange

reflects the countrys economic system and strength. As defined in FEMA ,

Foreign Exchange includes deposits, credits, drafts, travellers cheques, letters

of credit, bills of exchange payable in foreign currency. Under FEMA

foreign exchange transactions have been divided into two broad categories

current account transactions and capital account transactions.

CAPITAL ACCOUNT TRANSACTIONS: Transactions that alter the

assets and liabilities of a person resident in India (or) a person resident

outside India have been classified as capital account transactions.

CURRENT ACCOUNT TRANSACTIONS: All transactions other than

capital account transactions that do not alter the assets and liabilities of a person

& including dues against foreign trade, short term banking and credit

facilities, interest on loans / investments, remittance for living expense of

relatives living abroad.

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Reserve bank has notified comprehensive simple and transparent

regulations under FEMA, 1999 governing various capital account transactions.

The new regulations clearly indicate the types of permissible capital account

transactions and Simplified procedures while granting more powers to

authorized dealers i.e. banks. Except as provided by the Act, no person shall in

foreign exchange (or) foreign securities, make remittance abroad, receive

payments from abroad, acquire (or) posses any foreign exchange foreign

security (or) foreign immovable property. Any Indian resident may hold, own,

transfer (or) invest in foreign currency, foreign security, (or) foreign property

abroad if these were acquired when he was resident abroad (or) inherited these

from a resident abroad.

FOREIGN EXCHANGE AND INTEREST RATE - RISKS

The exchange risk is defined as the net potential gains or losses which

can arise from exchange rate changes to the foreign exchange exposure of an

enterprise. The foreign exchange exposure covers all the transactions, assets and

liabilities of an enterprise which are denominated in currencies other than the

reporting currency of the enterprise. Thus exposure relates to the total value of

assets, liabilities or cash flows of an enterprise denominated in foreign currency

and exchange risk relates to the excess or shortfall in that exposure due to

exchange rate fluctuations. Thus exposure relates to absolute value and the riskrelates to the changes in the value.

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The foreign exchange risk can be broadly categorized as follows :

Conversion or transaction risk: The gain or loss arising out of

converting foreign currency into domestic currency is known asconversion risk. It arises on account of exchange rate fluctuations when

the foreign currency denominated transaction is settled and converted into

the domestic currency.

Accounting or translation risk: The risk arising out of translating the

assets or liabilities of the enterprise denominated in the foreign currency

in to domestic currency to show in the books without actual conversion

with reference to the earlier reported rate.

Economic or Sovereign risk: It arises out of the change in the many

attributes like interest rates, inflation, political scenario, exchange control,

regulatory measures. Etc of other countries but affects the exchange rate

between two currencies. These risks are less clearly perceived but have

wide ramifications with far reaching effects.

Interest rate - risks: Apart from the above a corporate is also exposed

to risk on account of fluctuation in the interest rates in the market. It

refers to the changes in the cash flows or future value of a firm on

account of changes in the interest rates. Interest is charged on either fixed

rate or floating rate basis. Whereas in case of floating rate, the interest is

linked to some bench marked rates like LIBOR or MIBOR or SIBOR

etc.. In fact in case of LIBOR, the interest rates are offered for different

tenors in different currencies.

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In case of Fixed interest rate, the risk arises out of change in the interest

rates in the form of opportunity cost. For example if the interest rate goes down

after taking loan on fixed rate basis then the differential rate can be considered

as loss of opportunity, However it is beneficial in case the interest rate rises.

In case of Floating interest rate, the risk arises out of the fluctuation in the

benchmark interest rates. The loss arises in terms of additional outflow on

account of rise in the interest rate. Any change in the interest rates also creates

capital risk in the form of change in the price of underlying investment.

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SIGNIFICANCE OF RISK MANAGEMENT

Risk is the likelihood, or probability, that a given adverse event will

occur and Risk management deals with the assessing the magnitude of impact ofsuch event on operations, financial reporting, and possibly strategy to mitigate

or reducing the impact if the event does occur. Some risks are discrete and

others are continuous with a range of possible results associated with such event

with a likelihood of occurrence. Measures for likelihood are also discrete or

continuous. Measures of potential impact may be in terms of possible disruption

of operations, monetary loss or impairment of strategic objectives. Since risksare inevitable, the desire to shadow the risks by maneuverable strategies to

manage them has become natural.

Todays business faces many risks which are either internally driven or

externally driven in nature. All these risks can be broadly categorized into Four

types with Two dimensions, as follows:

WHO IS INVOLVED IN RISK MANAGEMENT?

Customer

End-user

Project Team

Management Product Management

Related Projects

Subcontractors and Suppliers

Steps in the risk management process

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Identification of risk in a selected domain of interest

Planning the remainder of the process.

Mapping out the following:

1. the social scope of risk management

2. the identity and objectives of stakeholders

3.the basis upon which risks will be evaluated, constraints.

Defining a framework for the activity and an agenda for identification.

Developing an analysis of risks involved in the process.

Mitigation of risks using available technological, human and

organizational resources.

Risk identification :

Comprehensive risk identification using a well-structured systematic

process is critical. Risk Champion should identify risks at the Business

Function. Risks can be identified in a number of ways, like conducting

Workshops, Brainstorming, Interviews , Press and media searches, Seminars,

Discussion with peers etc.

Effectiveness of risk identification tools is measured in terms of weighted

average score in the scale with a range of 1 to 7 i.e. low to high. Weighted

Average score with 1 shows low effectiveness and 7 shows high effectiveness.

The risk identification tools are as follows

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round table debates on key risks

interactive workshop

strategic risk reviews

specific studies/surveys

structured interviews

management reports

checklists / questionnaires

Risk Measurement Matrix

The identified risks are put in a matrix form by observing the following few

steps :- Risk are segregated into separate risk category

- Risk owner is appointed for each risk category

- A measurement scale is established to rate the risks as being high, medium,

or low impact / probability

- The measurement scale may be quantified in rupee terms of the loss, Where

quantification is not possible, the occurrence of a particular Event may be

assessed.

- Measurement scale is used to assess the criticality of the risk.

- Accordingly, the risk information should be escalated to the required Level.

Further the impact of the risks is assessed in terms of the area of impact and the

likelihood criteria: Likelihood criteria- in terms of probability of occurrence on

a 5 point scale from very high, high, moderate, low and very low.

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Risk Assessment:

Risk is typically assessed along two dimensions. Risk assessment across

an enterprise requires a combination of qualitative and quantitativemethodologies. Quantitative assessment is possible when sufficient data

are available. Qualitative assessment methodologies may be used where

potential likelihood and impact are low or where numerical data and

expertise for quantitative assessments are not available. Qualitative

assessments may also be used for high-impact events that require

substantive expertise for assessment.

Risk Evaluation:

It is the process used to determine the Risk Management priorities by

comparing the level of perceived risks against pre-determined standards/

target risk levels or other criteria and to generate a prioritized list of risks

for further monitoring and mitigation. There may be a range of possible

outcomes associated with an event.Risk evaluation helps in assessing the

Consequences/ Impact of the outcome of an event expressed qualitatively

or quantitatively, being a loss, injury, disadvantage or gain. The output of

a risk evaluation is a prioritized list of risks for further action .The Risks

ratings are the combined scores of likelihood and impact of the outcome

of an event. Risks are prioritized in three categories:

High ( Red zone or unacceptable )

Medium ( Yellow zone or cautionary )

Low ( Green zone or acceptable )

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Financial Risks and Integrated Risk Management System

Financial risks

Now a days businesses face many risks while executing the transactions

or holding the exposure in asset, liability or commodity including

currencies. The internal driven financial risks like cash management,

Debtors collection, credit availment, investment of Surplus funds etc are

more focused on the Organizations managerial acumen and the

external driven financial risks are more market oriented, which is

influenced by the environmental forces such as credit policies, liquidity

growth, interest rates, taxation laws, accounting standards, exchange rate

fluctuations, commodity risks etc..

With the liberalization of economy by moving away from the erstwhile

enforcement of draconian laws to user friendly regulatory measures and

globalization of trade/services by lifting the international trade barriers,

reduction of taxes & duties on imports, taxation incentives, creation of

SEZs, entering into FTAs and adopting uniform currencies across

countries lead to greater convergence of national and international trade.

This changing scenario not only benefits the consumers but also

encourages to change the socio economic needs of the people. Different

currencies, trade practices, economic elements put the firms into greaterfinancial risks unless the firm is suitably geared up to meet such

challenges by looking at the opportunities out of such risks.

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Forex Risks

The foreign exchange ( Forex) risks can be defined as the risks arising out

of the transactions involving currencies of different countries. Risk is thepotential for change in the price or value an asset or commodity. It is not

correct to interpret risk as a potential loss. Depending upon the potential

in the risk, the return can move upward or downward. Risk and Return in

a decision making process move together in same direction. It largely

depends upon the risk appetite of the organization to accept the risk

exposure or hedge it.

Risk identification and measurement : It is an important step in the

mechanism of risk management. Wrong identification will lead to basis

risk i.e. risk assumptions. The risks associated with the international trade

arise out of the exposures on account of transaction or conversion,

Accounting or translation or Operating or economic fronts. Broadly the

risks on these transactions involving commodities, assets or liabilities can

be classified into few categories as follows :

a) Conversion risk: Risk arising out of converting one currency into another

with or without any underlying transaction.

i) Exchange rate: The rate at which the currency is converted in to other

currency.

ii) Accounting: The rate at which the currency exposure is translated in

the books of accounts.

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b) Economic risk: It arises out of the change in the interest rates and the

inflation prevailing in the Two countries.

c) Sovereign risk: It arises out of the change in the political scenario, exchangecontrol, regulatory measures etc of the Two countries.

d) Liquidity risk: This implies the market depth of the currency.

The exposure must be analyzed to arrive at the various components of

risk associated with it. The corporate is exposed to risks both on account

of fluctuations in the exchange rate and interest rate as well for the

repayment to be made in future. Even a simple import /export transaction

can affect the bottom line of the organization unless a prudent risk

strategy is adopted.

The risk measurement involves the assessment of potential downside

the corporate could face if the risk remains un-hedged. The corporate has

to assess about the extra fund required in case the domestic currency

becomes weaker or the interest rate move higher.

Risk control and monitoring:

Analysis of Sensitivity to various risks that corporate faces assumes

considerable significance. Corporate has to analyze the decision of hedging the

risk vis--vis keeping the exposure open and the resultant impact. The hedging

decision will depend upon the risk appetite and the cost of hedging. If the

expectation shows a hit on the bottom line due to fluctuations then corporate

would tend to hedge with smaller cost rather than facing it. The risk appetite of

corporate hinges upon the sensitivity to risk. After analyzing the risk

component, corporate can actually go about setting the risk

hedging guidelines, deciding the limits and setting prudent

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risk norms. Based on the exposure undertaken and the

sensitivity to the risks presented by the exposure, corporate

can decide on when to hedge and how much of the exposure

to hedge. Corporate can assign risk weights to various

exposures and then look to arrive at an over all risk

weighted figure. Corporate can set up various models to

track the risk amount at any point of time.

Integrated Risk Management System (IRMS)

At a world class level, the Four dimensions of effective Integrated Risk

Management System are:

1. Risk culture -the degree to which management recognizes the need for

management competency and establishes standards and protocols for risk

management processes. This culture encompasses an organizations appetite

and tolerance for risk in its daily operating activities.

2. Risk management structure -the form used to assign responsibility for risk

management and to create a common process for assessing and communicating

risk issues from detailed process levels to the highest levels of decision-making

in an organization.

3. Resources - managements commitment to building a risk management

competency risk management leaders and process facilitators, development of

learning and education programs for employees and establishment of effective

risk management monitoring functions.

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4. Tools and techniques -the policies, processes, risk language and technology

based tools for managing risk.

The risk management practices revolves in a cyclical order from the

identification of risks till review of hedging mechanism adopted to mitigate or

reducing the impact of the risks and to adopt better methods by learning from

the experiences in the past. The cycle starts with identification of risks,

quantification of risks, adoption of strategy, hedging mechanism (if any) and

review. The strategies depend largely upon the risk environment and the risk

appetite of the organization.

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HEDGING MECHANISM

EXTERNAL HEDGING:

Forward contract hedge

Forward contract has been most widely used form of hedging exchange rate

risk. In a Forward contract, the acquisition or disposal of foreign exchange is

done at a pre determined exchange rate for settlement on a future date. Thus an

exporter who is expecting to receive the foreign exchange after 6 months can

sell this amount to bank under a forward contract so that the receivable can be

realized by the exporter at the forward rate irrespective of the prevailing rate on

the date of realization. Also there is an element of opportunity loss or gain by

entering into forward contract based on the movement of actual spot rate on the

date of settlement vis--vis the forward rate. However at the time of hedging or

entering into forward contract it is not possible to predict about the spot rate on

the date of settlement in future.

Money market hedge

Under this method the risk is covered by borrowing in foreign currency

converting the same into home currency and investing in the money market to

neutralize the position.

Futures

Futures are standardized contracts covering selective currencies in specific lots

and with specific periods. It is not flexible in nature as the size of the futures

may not match with the value of transaction and there by a part of the

transaction may remain uncovered or there may be excess in the coverage

without underlying risk.

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Currency options hedge

Exposure to movements in foreign exchange rates and currency market

volatility can be an advantage, particularly to currency speculators. While someregard any forex risk with alarm and hedge it as soon as it occurs, some hedge it

actively. Others never use the forward forex market and regard all windfall

profits or losses as "acts of God".

All corporate treasurers, hedging their forex exposures with forward

contracts, are aware that forward contracts are the best hedging instruments for

safeguarding against adverse rate movements. This flexibility of currency

options, however, carries a price tag with it in the form of option premium,

which is usually payable upfront.

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

the holder or the buyer thereof, the rightbut 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.

Options on spot currencies are commonly available in the inter bank

over-the-counter markets while those on currency futures are traded on

exchanges like the Chicago Mercantile Exchange (CME) and the Singapore

International Monetary Exchange (SIMEX).

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Terminology

Call Option

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

Maturity Date

Date on which the option expires.

American Option

A call or put option that can be exercised by the buyer on any business day up to

and including the maturity date.

European Option

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

Volatility

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The greater the chances of the underlying currency moving higher or lower over

the maturity of the option, the higher will be the premium. The statistical

measure normally used to gauge the volatility of markets is the standard

deviation, more correctly the standard deviation of daily percentage changes in

the underlying price. Volatility describes the size of likely price variations

around the trend rather than the trend itself. The figure is usually annualized to

give a constant measure. For instance, annualized volatility of 20% means that

the currency has a 68% chance of being up or down within a 20% band within

one year. It is possible to convert this figure into a daily volatility measure by

dividing the annualized volatility by the square root of the number of trading

days in a year (sq. root of 250 = 15.8). For instance, with spot euro at 0.87 and

volatility at 13%, there is a 68% probability that the spot rate will range between

0.8628 and 0.8772 in a one-day period.

Volatility is a key variable in option pricing. For at-the-money options, the

relationship is almost linear.

Interest rate differentials

The effect of interest rates on option premiums is the least obvious, and yet,

particularly with currency options, it is one of the most important components

of the premium. For stock or commodity options, higher the interest rate, higher

is the call option premium. This is so because higher the interest rate, greater isthe opportunity cost of funds, which have to be deployed to buy the concerned

stocks or commodities. In currency options, the situation is complicated by the

fact that there are two interest rates involved, the domestic interest rate and the

foreign interest rate . In this case, since the euro is priced in terms of the dollar,

the domestic interest rate is that for the dollar and the foreign interest rate is that

for the euro. The premium of an euro call option will increase if the dollar

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interest rate rises or the euro interest rate falls because in either case the cost of

holding euros increases.

HEDGING WITH CURRENCY OPTIONS

The objective of including currency options in hedging arsenal has

obviously to be to get the best protection available at the least possible cost.

This is easier said than done. However, a corporate with foreign currency

payables say in euro could use the following decision tree as a guide:

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Currency hedging decision tree

View of currency View of risk Action

Very bullish Risk averse Buy currency forward

Very bullish Risk tolerant Buy currency forward

Bullish Risk averse Buy currency forward

Bullish Risk tolerant Buy atm call

Flat market Buy ootm call

Flat market Risk tolerant Do nothing *

No view Risk averse Buy atm call

No view Risk tolerant Do nothing *

Bearish Risk averse Buy ootm call

Risk averse Risk tolerant Do nothing *

Risk averse Buy far ootm call

Very bearish Risk tolerant Do nothing *

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Currency swaps

Definition:

A currency swap is a contract which commits two counter parties to

an exchange, over an agreed period, two streams of payments in different

currencies, each calculated using a different interest rate, and an exchange, at

the end of the period, of the corresponding principal amounts, at an exchange

rate agreed at the start of the contract.

Example:

Bank UK commits to pay Bank US, over a period of 2 years, astream of interest on USD 14 million, the interest rate is agreed when the swap

is negotiated; in exchange, Bank US commits to pay Bank UK, over the same

period, a counter stream of sterling interest on GBP 10 million; this interest rate

is also agreed when the swap is negotiated. Bank UK and Bank US also commit

to exchange, at the end of the two year period, the principals of USD 14 million

and GBP 10 million on which interest payments are being made; the exchangerate of 1.4000 is agreed at the start of the swap.

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We can now see from the above that currency swaps differ from interest rate

swaps in that currency swaps involve:

An exchange of payments in two currencies.

Not only exchange of interest, but also an exchange of principal amounts.

Unlike interest rate swaps, currency swaps are not off balance sheet

instruments since they involve exchange of principal at the end of the

period.

The idea of entering into the currency swap is that, Bank US is probably

expecting an amount of GBP 10 million at the end of the period, while

Bank UK is expecting an amount of USD 14 million, which they agreed

to exchange at the end of the period at a mutually agreed exchange rate.

The interest payments at various intervals are calculated either at a fixed

interest rate or a floating rate index as agreed between the parties.

Currency swaps can also use two fixed interest rates for the two different

currencies different from the interest rate swaps.

The agreed exchange rate need not be related to the market.

The principal amounts can be exchanged even at the start of the swap

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If in the above-mentioned swap, the two banks agree to exchange the principal

at the beginning.

Bank UK will sell GBP to Bank US in exchange for US Dollars.

This would be at an exchange rate, most likely the spot rate.

These banks would borrow the respective currencies, which they have

sold.

But at maturity, this exchange of principal would be reversed at the

original exchange rate. (This kind of swap is called a par swap).

Types of Currency Swaps

Cross-currency coupon swaps

These are fixed-against-floating swaps.

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Cross-currency basis swap

These swaps involve payments attached to a floating rate index for both the

currencies. In other words, floating-against-floating cross-currency basis swaps.

Risk Management with currency swaps:

Example : Principal exchanged at Maturity

A UK Co. With mainly sterling revenues, has borrowed fixed-interest dollars in

order to purchase machinery from the U.S. It now expects the GBP to

depreciate against the USD and is worried about increase in its cost of

repayment.

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It could now hedge its exposure to a dollar appreciation by using a GBP/USD

currency swap. It would fix the rate at which the company, at maturity, could

exchange its accumulated sterling revenues for the dollars needed to repay the

borrowing. Fixing the exchange rate hedges the currency risk in borrowing

dollars and repaying through sterling.

Assuming, the Company expects not only the dollar to appreciate, but also the

GBP interest rates to fall. It could take advantage of this situation, by swapping

from fixed-interest dollars into floating interest sterling.

Stages

I. At the start of the swap, the GBP/USD rate is agreed at which the

principal amounts will be exchanged at maturity (probably, the prevailing

GBP/USD spot rate)

II. At the same time, interest rates for use in the swap are also agreed

III. Over the life of the swap, the UK Company will pay a stream of sterling

floating interest through the swap and will receive a counter stream of

dollar fixed interest in exchange. The dollar interest received through the

swap will be used to service the dollar borrowing; the sterling interest

paid through the swap will be funded from earnings.

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IV. At maturity, the company will pay a sterling principal amount through the

swap and receive a dollar principal amount in exchange. The exchange is

made at the GBP/USD rate agreed at the start of the swap. The company

will fund its payment of principal through the swap from accumulated

sterling earnings from its business.

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Letter of Credit

When the export draws a bill of exchange on the importer he faces the

risk of repudiation of the contract by the importer. The superior method ofsettlement of debt was devised which could assure the exporter that if he

exports the goods as per the contract entitled into with the importer and

produces evidence to that effect, he would receive payment without default.

Letter of Credit is an undertaking by the importers bank that if the

exporter exports the goods and produces documents as stipulated in the letter,

the bank would make payment to the exporter. Thus the obligation of the

importer under the contract is supplemented by a superior obligation of a bank

to make payment. The exporter now looks into the bank which opened the

Letter of Credit for payment instead of relying on the importer.

Mechanism of the Letter of Credit

Article 2 of the uniform customs and practices for documentary credits (UCP)

defines a Letter of Credit as to mean any arrangement, however named or

described, whereby a bank (the issuing bank), acting at the request and on the

instructions of a customer (the applicant) or an own behalf.

1. Is to make a payment or to the order of a third party (thebeneficiary) or is to accept and pay bills of exchange drawn by the

beneficiary or

2. Authorises another bank to effect such payment, or to accept and

pay such bills of exchange, or

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3. Authorises another bank to negotiate, against the stipulated

documents, provided that the terms and conditions of the credit are

complied with.

A clear understanding of above definition will be facilitated if one

understands how a Letter of Credit operates. A summary of a stages in the

operation of a Letter of Credit is given below.

Operation of a Letter of Credit

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Exporter London

(Beneficiary) Ships Goods to(5)

Importer Mumbai

(Applicant)

Presents Documents and Recovers

obtains payment from (6) amount from (8)

Obtains Reimburse-

ment from (7)

Utilization of Letter of Credit

1. The transaction originates when the exporter in London and the importerin Mumbai enters into the contract of sale. The contract covers all

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Midland Bank

London

(Negotiation

Bank)

Bank of India

Mumbai

(Issuing Bank)


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important particulars such as the descriptions, value and quantity of

goods, the due date for shipment, method of payment etc. One of the

stipulations is that a letter of credit should be opened in favour of the

exporter.

2. The importer applies to his bank (Bank of India) requesting and

authorizing the bank to open a letter of credit in favour of the exporter

and pay bills drawn by the exporter under the letter of credit. The

application would stipulate the conditions, especially with regard to the

documents to be submitted by the exporter along with the bill.

3. Though the letter of credit is addressed to the exporter, it would normally

be sent to the correspondent bank of Bank of India in London (Midland

Bank) with a request to forward it to the beneficiary. When it is sent to

the Midland bank which, in the capacity of corresponding bank is in the

position of the signature of the officials of Bank of India, the signature on

the credit are verified before it is forwarded to the exporter.

4. Within the stipulated date of shipment, the exporter ships the goods to a

port in the importers country (Mumbai) and obtains bill of lading from

the shipping company.

5. The exporters bank verifies the documents to make sure that they satisfy

the conditions stipulated in the letter of credit and pay the amount to the

exporter. Then the documents forwarded to Bank of India for payment.

6. On receipt of the documents after verifying that they satisfy the

requirements of the letter of credit, Bank of India makes payment to

Midland Bank. The amount of the bill would be recovered by the bank

from the importer and the documents would be delivered to him.

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By this time, it would have been understood that in credit operations all parties

concerned deal in the documents, and not in goods, services and/or other

performance to which the documents may relate. (Article 4). Thus, though the

seller under the letter of credit is assured of payment, the buyer has no

guarantee that required the goods have been exported to overcome this

difficulty the credit may specify some other documents to accompany the bill.

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7/28/2019 F

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