Project Shiva

8/6/2019 Project Shiva

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ACKNOWLEDGEMENT

The satisfaction that accompanies the successful completion of any task would be incomplete

without the mention of people who made it possible and whose constant guidance,

encouragement, and cooperation crown all the efforts with success.

I would like to express my deep sense of gratitude to Prof. MANOHAR RAMESH and

Mr.Mohan, my head academics Prof.H.V.Prakash For his guidance, constant

encouragement and fruitful suggestions during the entire period of this dissertation internship

work.

I heartfully thank my campus head Mrs.Sasmita Bebortha for her great encouragement and

co-operation through out the project and for providing global exposure.

I would like to thank the managers and assistance manager of MINDLANCE for sharing

their valuable time with me by giving necessary details.

I would like to thank the staff, who supported me directly or indirectly and for their good

wishes and constructive criticism, which led the successful completion of this project.

I specially thank my projectmates to share feelings about the project.

Project associate

B.Siva Nagarjuna


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The Foreign Exchange Markets

A market is a place where buyers come to buy and where sellers come to sell. The foreign

exchange market is a place where buyers come to buy and sellers come to sell foreign

monies, such as Mexican Pesos, Japanese Yen, British Pounds, European Euros, Canadian

Dollars, and so forth. In the foreign exchange market, buying and selling takes place through

the interaction of large banks all over the world. These banks, acting on behalf of their

customers, interact through computer communication. On the other hand, much buying and

selling in the stock market is done by brokers in a specific place, such as the Bombay Stock

Exchange in Bombay.

WHAT, WHERE, WHEN

y An exchange rate is the relative price of two monies, like the Indian rupees price of the

U.S. dollar (Rs/$), or the U.S. dollar price of the British pound ($/).

y Foreign exchange means the money of a foreign country that is, foreign currency bank

balances, banknotes, checks, and drafts.

y The foreign exchange market provides the physical and institutional structure through

which the money of one country is exchanged for that of another country, the rate of exchange between currencies is determined, and foreign exchange transactions are

completed.

y Functions of the FOREX market:

Transfer of purchasing power

Provision of credit

Minimizing foreign exchange risk

y A foreign exchange market is a very large over-the-counter market with an interbank and

retail part.

y The traders are trading from foreign exchange desks in banks in major financial centers

such as New York, Chicago, San Francisco, Tokyo, Hong Kong, Singapore, Bahrain,

Frankfurt, Zurich, Paris, and London. There is almost 24 hour trading. (See Exhibits 1 &

2)


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Exhibit 1


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Exhibit 2

Source: The Economist , September 23,

Exhibit 3The Top 20 Foreign Exchange Dealers


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Exhibit 4:- Foreign Exchange Markets

Top 30 by % share of foreign exchange market

97 96 Bank Estimated share (%)

1 1 Citibank 8.30

2 4 NatWest 5.62

3 24 Merrill lynch 5.18

4 9 Deutsche Morgan Grenfell 4.79

5 2 Chase 4.65

6 10 SBC Warburg 4.43

7 5 JP Morgan 4.40

8 14 Goldman Sachs 3.82 9 3 HSBC Midland 3.24

10 7 BZW 3.14

11 8 Bank of America 2.56

12 12 Credit Suisse First Boston 2.39

13 19 Bank of Tokyo-Mitsubishi 2.14

14 6 Union Bank of Switzerland 1.87

15 11 ABN Amro Hoare Govett 1.82

16 28 Commerzbank 1.78 17 - Sumitomo Bank 1.69

18 - Dai-Ichi Kangyo Bank 1.68

19 17 Royal Bank of Canada 1.64

20 13 Standard Chartered 1.60

21 - Morgan Stanley 1.43

22 25 First Chicago 1.41

23 - AIG International 1.33

24 26 Societe Generale 1.32 25 - Sanwa Bank 1.19

26 27 Fuji Bank 1.17

27 22 Bankers Trust 1.16

28 16 S-E-Banken 1.08


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29 - Dresdner Kleinwort Benson 1.07

30 15 Banque Indosuez/Credit Agricole 1.03

Exhibit 5

Major Foreign Exchange Trading Centers(Average daily volume during April of 1989, 1992, 1995, 1998)

0London New Y ork Tokyo

1989 1992 1995 1998

100

200

300

400

500

600

700


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MARKET PARTICIPANTS

y Importers, Exporters, International Portfolio Investors, Multinational Firms, and Tourists

This groups transactions result in commitments to make or receive payments in foreign

currencies, and the need of this group for currency conversion that supplies the foreign

exchange markets basic justification for existence.

y Bank and Non-Bank Foreign Exchange Dealers

(See Exhibits 3 & 4)

Forex dealers derive income by buying currencies at lower prices than the prices at which

they sell currencies.

Dealers operations are divided into the wholesale (or interbank) and retail levels of

operation.

At the interbank level, dealers alter their currency inventories by transacting on a large

scale, typically for more than $3 million per transaction. At the retail level, dealers cater

to the need of customers wishing to buy or sell foreign exchange on a small scale.

The bid-ask spread in retail transactions is much wider than that in interbank transactions.

y Foreign Exchange Brokers

Forex brokers bring buyers and sellers into contact with each other on a commission

basis. They exist because they lower dealers costs, reduce their risks, and provide

anonymity.


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For their services, brokers receive commissions, typically 0.01% of the transaction

amounts in interbank trades.

y Speculators and Arbitrageurs

Speculation

In the broader sense, speculation means to accept an open/unhedged position

denominated in foreign currency.

In the narrower sense, speculation occurs when someone transacts in foreign

exchange primarily or entirely because of an anticipated but uncertain gain as a result

of an exchange rate change.

Illustration: Barclays dealers in action

On one Wednesday in 1987, the Barclays Bank in Britain speculated that the pound

would rise that afternoon.

Arbitrage

Arbitrageurs make gains by discovering price discrepancies that allow them to buy

cheap and sell dear.

Three types of arbitrage in the FOREX market:

1. Arbitrage between different quotes for same currency

2. Triangular arbitrage dollar rates versus cross rates


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$

US$

US

v!

3. Covered interest arbitrage

y Central Banks or Governments

Both political and economic considerations move governments to intervene in the forex

market. Government intervention may be designed either to stabilize an exchange rate or

to move it to a new level.

SIZE OF THE MARKET

y Huge, recent estimates of daily turnover at over US$1 trillion. (See Exhibit 4.5)

y Up until a few years ago, the composition of trading activity was approximately as follows:

Interbank: 85%Capital movements: 10-15%

Trade flows: < 5%

Recently, professional fund managers have become more important players.

TYPES OF TRANSACTIONS

y Spot purchase of foreign exchange with delivery and payment between banks to be

completed, normally, on the second business day.

The settlement date is called valu e d a te.

y Forward requires delivery at a future value date of a specified amount of one currency for a


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specified amount of another currency. The exchange rate is established at the time the

contract is agreed on, but payment and delivery are not required until maturity.

The typical contracts are for a maturity of 1, 2, 3, 6, and 12 months.

About 60% of foreign exchange transactions are in the forward market.

y Swap simultaneous purchase and sale of foreign exchange for two different value dates. A

common type of swap in the interbank market is spot against forward.

Demand for Foreign Exchange

Why would anyone buy foreign exchange (the money of a foreign country)? If you have

traveled in a foreign country, you have probably bought the money of that country. This means

that you have exchanged your rupee for the money of that country. Otherwise, you most likely

have not participated in a foreign exchange market. But a large number of businesses and

individuals do participate in this market. There are basically four reasons they do so.

I. The main reason to buy foreign exchange is to be able to buy foreign goods and

services (called impo rt i ng ).

Suppose you wish to buy your BMW. You buy it from a dealer in the United States. The

dealer buys it from an importer. The importer buys it from the BMW Corporation located in

Munich, Germany. The BMW Corporation wishes to be paid in Euros, the money of Europe

since 2002. So the importer would have to buy the Euros to pay for the BMW automobiles.

Lets say the importer needs 100,000 Euros to buy your BMW automobile. The importer goesinto the foreign exchange market by going to an American bank, such as Bank of America. Bank

of America communicates with a German bank (such as Deutches Bank) to help the American

importer obtain the Euros it needs. The importer will give $100,000 that it already owns to Bank

of America and will get the 100,000 Euros in return (assuming that $1 exchange for one Euro).

Bank of America gets the 100,000 Euros by sending the $100,000 to Deutsches Bank. Deutsches


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Bank gets the 100,000 Euros from one of its customers, Mr. Schmidt. Mr. Schmidt gives the

100,000 Euros that he owns to Deutsches Bank because Mr. Schmidt desires to have the

$100,000. With the two banks as intermediaries, the importer has given up the $100,000 that it

owned and received in return 100,000 Euros that it will use to buy your BMW automobile. Mr.

Schmidt has given up the 100,000 Euros that he owned and received in return $100,000 that he

will use to buy some new computers for his business from IBM.

We buy foreign exchange in order to buy foreign-made goods and services. (Travel is

considered as buying a service.) . First we will buy foreign-made goods and services if they are

relatively cheaper than Indian-made goods and services. This involves comparing the prices of

the Indian-made goods and services to the prices of the foreign-made goods and services, their

substitutes.

(1) If the prices of Indian -made goods and services increase, the demand for foreign-made

(imported) goods and services will increase. This will increase the demand for foreign exchange.

Conversely, if the prices of Indian -made goods and services decrease, the demand for foreign-

made (imported) goods and services will decrease. This will decrease the demand for foreign

exchange.

(2) On the other hand, if the prices of foreign-made (imported) goods and services increase, the

demand for foreign-made (imported) goods and services will decrease. This will decrease the

demand for foreign exchange. Conversely, if the prices of foreign-made (imported) goods and

services decrease, the demand for foreign-made (imported) goods and services will increase.

This will decrease the demand for foreign exchange.

People may also buy foreign-made goods and services because they like them (tastes and

preferences). Either they believe that the foreign-made goods are of higher quality or they like

the idea that they are foreign.

(3) If people like foreign-made products more, the demand for foreign-made (imported) goods

and services will increase. This will increase the demand for foreign exchange. Conversely, if


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people like Indian -made products more, the demand for foreign-made (imported) goods and

services will decrease. This will decrease the demand for foreign exchange.

Finally, when incomes of buyers rise, they will buy more of all kinds of goods and services.

This means that they will also buy more foreign-made goods and services. Therefore,

(4) an increase in incomes will increase the demand for foreign-made (imported) goods and

services. This will increase the demand for foreign exchange. Conversely, a decrease in incomes

will decrease the demand for foreign-made (imported) goods and services. This will decrease

the demand for foreign exchange.

II. A second major reason people buy foreign exchange is called portfolio investment . Portfo l io in vestment me a ns l ending money to someone in a nother co u ntry .One would lend

money to someone in another country by opening a checking or savings account in a bank in

another country, by buying a bond of a company in another country, by buying a bond of a

government of another country, and so forth. Why would anyone open an account in a foreign

bank, lend money to a foreign company, or lend money to a foreign government? (Buying a bond

is a form of lending money.) One major answer is that, when they borrow from you, the foreign

banks, businesses, or governments will pay you a higher rate of interest. Suppose you have

$10,000 that you wish to keep in a savings account. The bank in the United States will pay you

interest of 2% per year. Suppose a bank in Canada will pay you interest of 15%. What do you

do? Assuming the risks are about the same, you will open the savings account in the bank in

Canada. Of course, to do so, you will have to convert your American dollars into Canadian

dollars. So, when interest rates rise in foreign countries, Americans are more likely to lend

money in the foreign countries (in order to be able to get the higher interest). Therefore, the

demand for foreign exchange increases. Conversely, when interest rates fall in foreign countries,

Americans are less likely to lend money in the foreign countries. Therefore, the demand for

foreign exchange decreases. On the other hand, when interest rates rise in the United States,

Americans are less likely to lend money in foreign countries (and more likely to lend money at

home). Therefore, the demand for foreign exchange decreases. Conversely, when interest rates


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fall in the United States, Americans are more likely to lend money in foreign countries (and less

likely to lend money at home). Therefore, the demand for foreign exchange increases.

III. A third major reason people buy foreign exchange is called foreign direct investment.

F ore i gn Di rect Invest ment i nvol ves own i ng and c ontr olli ng a c omp any i n an other

cou ntry .

Technically, one controls a company if one owns at least 10% of the shares of stock.

General Motors of Britain, Germany, or Mexico are examples of foreign direct investment by an

American-owned company. Honda of Ohio and Nissan of Tennessee are examples of foreign

direct investment in the United States by Japanese-owned

companies. If General Motors wishes to build a company in Mexico, it will have to pay for it

with Mexican pesos. Therefore, the demand for foreign exchange (Mexican pesos) rises. If Honda wishes to build another automobile factory in the United States, it will have to pay for it

with American dollars. Therefore, the Japanese demand for foreign exchange (American dollars)

rises.

IV. There is one more important reason to buy foreign exchange --- expectations

The foreign exchange market is one for which expectations are very important. If one

knew about changes in foreign exchange rates before anyone else knew, one could make a

considerable fortune. So, if you as an American expect that Mexican pesos will go up in price in

the near future, your demand for them now will increase. Conversely, if you expect that

Mexican pesos will go down in price in the near future, your demand for them now will

decrease.

Let us summarize. The demand by Indians for foreign exchange will increase if:

1. the prices of Indians made goods and services rise

2. the prices of foreign-made goods and services fall

3. people like the foreign-made goods and services better

4. Indians have higher incomes

5. Interest rates rise in foreign countries or fall in the India.

6. Indians companies have a greater desire to build or buy companies in foreign


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Countries.

7. Indians expect that the price of foreign money will rise in the near future

The opposite changes will cause the demand by Indians for foreign exchange to fall.

Supply of Foreign Exchange

Once we understand all of the factors that determine the demand for foreign exchange, it is

easy to discuss the supply of foreign exchange. Who is selling foreign exchange on the foreign

exchange market? The answer, of course, is foreign people. Why would they sell their money to

you? The answer is that they want something from you --- your dollars. In the foreign exchange

market, everyone is both a buyer and a seller. You buy Mexican pesos by selling your rupees to

someone from Mexico. In the example above, Mr. Schmidt is selling his Euros in order to get

rupees so he can buy computers. The supply of foreign exchange is the same as the demand for

rupees. Since they are selling their money in order to obtain your rupees, the questions becomes

why do they want your rupees? The answer is that they want your rupees for the same reasons

you want their money. They want your rupees because they want to buy Indian-made goods and

services (because the prices of their own goods and services have risen, because the prices of

Indian-made goods and services have fallen, because they like the Indian-made goods andservices better, or because their incomes have risen). They want your rupees because interest

rates rose in the India or because interest rates fell in their own country. They want your rupees

because they wish to build or buy companies in the India. And finally, they want your rupees

because they expect that the price of the rupees in the foreign exchange market will rise in the

near future .

Equilibrium

As in any market, the price of foreign exchange is determined by the demand for it and the

supply of it. This is shown in the graph below. Remember that the demand for foreign exchange

reflects the behavior of Indians in the foreign exchange market. And the supply of foreign

exchange reflects the behavior of foreigners in the foreign exchange market. In this graph, the


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foreign money is Japanese yen. Indians are the ones who buy them. Japanese are the ones who

sell them. The price of foreign exchange is given a distinct name: the foreign exchange rate.

Rs. Per Yen

Supply of Japanese Yen

P1 E

Demand for Japanese Yen

0 Quantity of Japanese Yen

How Foreign Exchange Works

The forex market is a huge international exchange where different currencies are traded, i.e. both

bought and sold. It is estimated to be the largest financial market in the world, and is not

governed by the rules of any one country. In addition to this, while it is open from Sunday to

Friday, it is a 24 hour market and does not experience a daily closing like a traditional stock

market. It is, thus, not regulated and there are no international panels to settle disputes nor are


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there any clearing houses to stand as guarantors of trades on the exchange. There is nothing more

binding than a credit agreement between the buyer and seller in the forex market, and it works.

While this seems very nebulous to most stock market investors, forex traders are forced by

xcompetition and the need for cooperation to remain honest. There is no way for a trader tosurvive in the forex market unless he or she keeps up their end of the deal. Most countries will

have their own body or association that serve to regulate the forex traders or brokers in that

country and ensure that clients' rights are protected. This association will insist on its members

accepting the decisions of their arbitration panel in case of disputes. In the United States, this

organization is generally considered to be the National Futures Association or the NFA.

Another important aspect of the forex market to keep in mind is that on the market itself, there

are no commissions, and thus it works on principal amount only. The so called forex brokers

make money not by taking a commission from the trading parties, but by facilitating the trade

itself and making their bit on the bid ask spread, i.e. the difference between the selling and

buying prices. The implication is that they are not brokers in the traditional sense of the word,

but more like forex traders themselves.

The single most attractive aspect of the forex market is that it is practically impossible for any

investor, group of investors or financial institutions to misuse it. It is such a large market, withmoney flowing through it daily in estimated trillions of dollars, that no single entity, however

large, can gain a statistically significant control over the forex market. This means that it is

completely free of any influences, beyond the true fundamental driving forces that move it. The

implication here is that this market offers every investor the same opportunity, regardless of size

or influence, making it a free and fair market place, possibly the only one in the world. This

aspect is very attractive to small investors in particular, since they are often the ones to suffer the

most from stock market scams and fraudulent activity.

While these factors make the forex market more appealing to invest money on, it is also hard to

make money on this market due to the fact that the forex trader has to always do better than the

bid ask spread, which makes the opportunities for arbitrage profit limited. However, with no

extra commissions and charges, the forex trader is left to enjoy every last bit of profit that he or


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she does make, once they are past the bid ask spread mark. Overall, the forex market is the place

for a smart, vigilant and well trained investor.

Functions of Foreign Exchange markets

Generally, the functions of the worlds major Fx market are to accommodate and

determine an exchange rate, which is determined through the basic principles of supply and

demand. An exchange rate is essential for a economy due to the potential of economic growth

that resides with exports and imports. International trade, Foreign investment, the demand for a

countrys rupees buy exporting firms in the same country (except service as well) and

employment are factors needing an exchange rate which allows the above to positively influence

an economy. Some other main functions of forex are:

Transfer of purchasing power.

Provision of credit.

Minimizing foreign exchange risk.

Accommodate and determine an exchange risk.

Exchange Rate Determination 1:-Introduction

This note discusses (briefly) the theories behind the determination of the exchange rate.

By no means this is supposed to be a treaty in the subject. I will leave important contributions

aside. Thus, here I mostly analyze what in my opinion are the most important ones.

2:-Theories PPP

The purchasing power parity approach to the exchange rate was, and continues to be, a

very influential way of thinking about the exchange rate. The PPP derives from the assumption

that in the world there exists the "law of one price". This law states that identical goods should

be sold at identical prices. This is far from a law (by the way), it is mainly an assumption.

For the purpose of the initial discussion let's believe it. The law of one price implies that

exchange rates should adjust to compensate for price differentials across countries. In other


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words, if we are in a banana-world (only bananas exists), and a banana is sold in US at 1 Dollar,

and the same banana is sold in Spain at 133 Pesetas, then the exchange rate has to be 133 Pesetas

per Dollar.

* p = p / e

This is the absolute PPP approach. Where p represent domestic prices, p* are foreign prices and

e is the exchange rate.

There is also the relative PPP approach. It is the same model but applied to differences: the

change in the exchange rate will compensate inflation differentials.

*1 + = (1 + )(1 + e )

*where and , represent domestic inflation, foreign inflation and the depreciation,

respectively. In other words, a 3 percent inflation rate in US and a 1 percent inflation rate in


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Japan should imply a depreciation of the Dollar versus the Yen by 2 percent.

The theory behind PPP is very appealing. However, when taken to the data, usually we do not

find PPP to hold in the short, nor medium, run and when we are lucky (truly lucky) we find that

it holds in the long run.

There are several important reasons for PPP not to hold in the long run:

1. The law of one price might not hold in the short run: The law of one price requires a perfect

arbitrage in goods. This means that individuals should be able to import and export any product

that are identical and have different prices across countries. This is hardly a good assumption in

the short run. And the fact that domestic markets are relatively oligopolistic in the short run

implies that indeed prices will differ. The real world is closer to one in which good segmentation

is relevant, both in the decision of production and pricing.

2. PPP assumes that there is no government intervention: Tariffs, Quotas, VER's, taxes, etc.

3. PPP might not even hold in the long run:

There is an important component of non-tradable goods, and productivity differentials in

those sectors might be different across countries. This implies that there is a permanent

change in the price level across countries that should not be compensated by the exchange

rate.

Taste might change, and thus the real exchange rate.

Market structures might change, and thus the equilibrium exchange rate.

Indeed, there are few cases in which PPP holds in the short run. And when it holds, it usually

economies with very high inflation rates (mostly hyperinflation) where domestic currency has no

meaning in the determination of prices, and the agents tend to dollarize their economies.

Balance of Payments Approach

This approach is mainly the BB-NN (or dependant economy). The idea is that there exists an

exchange rate at which there exists internal and external equilibrium. The internal equilibrium


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assumes that there is full employment: unemployment is in the natural rate of unemployment. Or

in other words, the unemployment is such that there are no pressures to change real wages.

The external equilibrium refers to equilibrium in the balance of payments. Sometimes, people

look at the current account instead of the balance of payments.

This is indeed a wonderful theory. It can explain permanent deviations of PPP, but also explain

PPP if so is required.

The main problem with this approach is that in general it is extremely difficult to determine what

is the exact natural rate of unemployment, nor the exchange rate consistent with an equilibrium

in the external accounts. We tend to think, again, that this is a good guess of the long run

exchange rate. This model will determine where the exchange rate has to converge to, however,

it provides very little guidance to the short term fluctuations.

Monetary and Portfolio ApproachesThis is an asset pricing view of the exchange rate. The idea is that agents have a portfolio choice

decision between domestic and foreign assets. Those instruments (either money or bonds) have

an expected return that could be arbitraged. This arbitrage opportunity is what determines the

process of the exchange rate.

In its simplest form, this approach implies the uncovered interest rate parity.

*

1 + it =

(1 + i )(1 + e E )where the idea is that if the expected depreciation does not compensates the interest rate

differentials, agents would have arbitrage opportunities.

This is an amazingly attractive theory. Unfortunately, works extremely bad. This is an area of

research where still today in economics, we have very little explanations for its failure.

3.-How they do in the data? I have already hinted in the previous section that all these theories perform quite badly in the

short run. Well, this is not strong enough. The performance is horrible! Moreover, in a lot of the

empirical exercises, not even the signs are correct.

4.-Government intervention


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Governments intervene in foreign markets frequently. The form of this intervention goes from

selling small amounts of foreign currency, domestic instruments, to sterilization and even buying

stocks in their own stock markets.

Obviously there are less interventionist central banks (such as the FED) to banks that think the

exchange rate is just a three dimensional Nintendo.

The most common form of intervention is called sterilization. The general idea is the following:

assume foreigners decide to invest at home and start buying home government bonds. The price

of the bonds goes up, due to the increase in demand, which implies a fall in the interest rate. In

the end, the reduction in the cost of capital increases aggregate demand pushing prices up. A

Central Bank who is concerned with inflation responds to the capital inflow with a tight

monetary policy. This tightening is what is called sterilization.

What occurs in the central bank is that there is an increase in reserves and a drop in domesticcredit. Thus, sterilization is just a portfolio re-composition of the Central Bank's assets.

Basic Exchange Rate Concepts

Nominal Exchange Rate

currencydomesticof unitcurrencyforeignof units

! N ome

Real Exchange Rate

goodsdomesticof unitgoodsforeignof units

goodforeignof pricecurrencyForeigngooddomesticof pricecurrencyForeign

!!! F or

N om

P P e

e

Dollar Appreciation

Nominal Appreciation: Dollar buys more units of foreign currency: o N ome

Real Appreciation: Sale of domestic goods purchases more foreign goods: oe


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Dollar Depreciation

Nominal Depreciation: Dollar buys fewer units of foreign currency: q N ome

Real Depreciation: Sale of domestic goods purchases less foreign goods: qe

Purchasing Power Parity

Goods have equal values in each country: 1!! F or

N om

P P e

e

Short-Run Real Exchange Rate Determination

While Purchasing Power Parity offers a reasonably satisfactory explanation of long-run

trends in nominal exchange rates, financial market conditions are more important for the

determination of the equilibrium real exchange rate in the short run. Suppose that some domestic

traders are interested in acquiring foreign assets, like foreign stocks or bonds. Such purchases

(net of foreign traders' purchases of domestic assets) are referred to as Net Capital Outflow

( NCO ). Net Capital Outflow is the net amount of payments made to foreigners for the purchase

of assets, so NCO is also identically equal to the Capital Account Deficit. That is:

CA KA NCO !!

We also find it useful to identify NCO as the supply of dollars in the foreign exchange

market. To engage in a positive amount of NCO , domestic residents must sell (supply) dollars to

buy the foreign currency needed to buy the foreign assets.

Currency transactions also result from trade in goods. In particular, when foreigners want to

buy U.S. goods, they need to exchange their own currency for dollars to make their purchases.

We therefore identify net exports ( NX ) as the demand for dollars in the foreign exchange market.

The other current account items, net factor payments and net unilateral transfers, also result in a

need to demand dollars, but we continue to assume that these two items are approximately zero.


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India has liberalized its foreign exchange controls. Rupee is freely convertible on

account. Rupee is also almost fully convertible on capital account for resident Indians for

incomes earned in India.

The RBIs foreign exchange department administers Foreign Exchange Management Act1999 (FEMA). Foreign Exchange management (transfer of securities to any person resident

outside India) Regulation as amended from time to time regulates transfer for issue of any

security by a person resident outside India.

Repatriation of Investment capital and profits earned in India:-

i. All foreign investments are freely repatriable, subject to sectoral policies and except for

cases where non resident Indians choose to invert specifically under non-repatriable

schemes. Dividends declared on foreign investments can be remitted freely through an

authorized dealer.

ii. Non-residents can sell shares on stock exchange without prior approval of RBI and

repatriate through a bank. The sale proceeds if they hold the shares on repatriation basis

and if they have necessary NOC/tax clearance certificate issued by income tax

authorities.iii. For sale of shares through private arrangements, regional offices of RBI grant permission

for recognized units of foreign equity in Indian company in terms of guidelines indicated

in regulation 10.B of notification on No. FEMA. 20/2000RB dated may 2000.The sale

price of shares on recognized units is to be determined in accordance with the guidelines

prescribed under regulation 10B(2) of the above notification.

iv. Profits, dividends, etc.... (Which are remittances classified as current account transaction)

can be freely repatriated.

Acquisition of Immovable Property by Non-resident:

A person resident outside India, who has been permitted by RBI to establish a branch, or

office, or place of business in India (excluding a Liaison Office) has general permission of RBI


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to acquire immovable property in India, which is necessary for, or incidental to, the activity .

However, in such cases a declaration, in prescribed form (IPI) is required to be filled with the

Reserve bank, within 90 days of the acquisition of immovable property.

Foreign nationals of non-Indian origin who have acquired immovable property in Indiawith the specific approval of the RBI of India cannot transfer such property without prior

permission from the RBI. Refer to the foreign exchange management 2000 (Notification

No.FEMA.21/2000RB dated may 3, 2000).

Acquisition of Immovable Property by NRI:

An Indian citizen resident outside India (NRI) can acquire by way of purchase any

immovable property in India other than agricultural or plantation property or farm house to a person resident outside India who is a citizen of India or to a person of Indian origin resident

outside India or a person resident in India.

Interest Rate and Foreign Exchange Rate Risk

Trading foreign exchange on margin carries a high level of risk and may not be suitable

for all investors. The high degree of leverage can work against you as well as for you. Before

deciding to trade foreign exchange you should carefully consider your investment objectives,level of experience and risk appetite. The possibility exists that you could sustain a loss of some

or all of your initial investment and therefore you should not invest money that you cannot afford

to lose. You should be aware of all the risks associated with foreign exchange trading and seek

advice from an independent financial advisor if you have any doubts.

Most economic agents face foreign exchange or interest rate risks when they have future cash

inflows or outflows arising from their capital investments, operations and financing. The main

factors that determine the magnitude of these flows, foreign exchange rates and interest rates,

both real (i.e. net of inflation) and nominal, are volatile. Indeed, there is a close correspondence

between foreign exchange and interest rates. Hence, one of the important tasks of financial


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management is to reduce the exposure of the agent to foreign exchange and interest rate risk

using various financial instruments.

For instance, if a firm needs to convert its foreign currency inflows or borrow money at a future

point in time, it can hedge its exposure to increases in these rates in a number of ways. The

principal instruments available for the hedging of foreign exchange and interest rate risk are

Forward contracts: A foreign exchange forwa rd contr a ct is an agreement made today to deliver

or take delivery of a specified amount of foreign currency in exchange for domestic currency, on

a future date, at a fixed exchange rate. An interest rate forward or a forwa rd r a te a greement

(FRA) is a contract made now to pay or receive the difference between the future rate of interest

and a fixed interest rate on a specified principal amount, over a given loan period. In the absenceof changes in credit risk, a FRA can be thought of as an agreement to borrow or lend money in

the future at a fixed rate of interest.

Futures contracts: F u t u res contr a cts are standardized contracts on foreign exchange and interest

rates that are traded on a futures exchange. They are based on the delivery of a specified amount

of foreign currency or an interest-bearing security, at a future date. Thus, both forward and

futures contracts are agreements to deliver or take delivery of a specified quantity of an asset on

a future date at a pre-specified price. However, the important difference between forward and

futures contracts is that the latter are marked-to-market on every trading day.

Option contracts: Interest rate o ptions give the holder the right to receive the difference

between the future rate of interest and a fixed interest rate, known as the strike r a te, on a

specified principal amount, over a given loan period. Again, in the absence of changes in credit

risk, an interest rate option can be thought of as the right to borrow or lend at a fixed rate. Note

that in contrast to forward contracts, the holder of the option is not obliged to borrow or lend at

the agreed rate, if market interest rates change to a level that is unfavorable.

Foreign exchange options confer on the holder the right to buy or sell a specified amount of

foreign currency at a fixed exchange rate, the strike rate, in exchange for domestic currency. As

in the case of interest rate options, the option holder would exchange the foreign currency only if

the previously fixed strike rate is favorable in relation to the prevailing market rate.


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Many firms and investors have cash flows denominated in multiple currencies. For firms

involved in transnational trade, manufacture and financing, these cash flows may be related to

the purchase of capital equipment or raw materials, and the sale of finished products, or

financing flows relating to borrowing and lending. In the case of investors, these flows may be

related to their investments and the return from the investments as well as the cash flows for

consumption. Cash flows in various foreign currencies may be hedged using forward or option

contracts, for short horizons. For longer maturities, it may be necessary to use foreign c u rrency

swa p s, ca p s and f l oors . A foreign currency swap is a portfolio, or a series, of foreign currency

forward contracts over multiple periods. Similarly, a foreign currency cap or floor can be

defined in terms of a series of foreign currency call or put options on the foreign currency.

Borrowers often require money over longer periods of time, for example, from 5 years to as long

as 100 years. To hedge over longer periods, borrowers can use an interest r a te sw a p contr a ct or

an interest r a te c a p or f l oor contr a ct . A swap is a portfolio, or series, of interest rate forward

contracts covering successive borrowing periods. Likewise, an interest rate cap or floor is a

series of interest rate option contracts. Most interest rate risk management is done with

FRA/futures, swap, cap and floor contracts.

Many hedging contracts, such as forward contracts and swaps, are made between banks and

corporate clients on what is known as the over-the-counter (OTC) market. These contracts are

often specially structured to suit the needs of the corporate client. Although the contracts

mentioned above are the common contracts of a standardized nature, there are other non-standard

instruments known as exotic or com pl ex deri va tives . Examples are knock-out options and swaps,

quanto options and differential swaps, Asian swaps and options, binary options, and compound

options. In contrast to the OTC contracts, other instruments, such as futures and some option

contracts, are exchange-traded (ET). The principal differences between OTC and ET contracts

are that the latter are

a) marked-to-market each trading day,

b) usually standardized contracts, and

c) have less counter-party or credit risk.


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Foreign exchange and interest rate volatility

There are many different interest rates in each currency. Interest rates differ according to the

maturity of the loan involved, the credit status of the borrower, and the currency that is beinglent. Of all these rates, perhaps the most important single rate is the three-month $LIBOR.

$LIBOR stands for London Interbank Offer Rate and is the average quote from five major

international banks, lending US $, in the London inter-bank market. Many corporate loan

agreements are linked to $LIBOR and most derivative contracts have payoffs that depend on this

rate. Similar interest rates are quoted in all the major currencies and various maturities of less

than one year. Collectively, these rates are referred to as money m a rket r a tes .

The development in the 1980s and early 1990s of the markets for interest rate and foreign

currency derivatives owes much to the volatility of these rates. Figure 1 illustrates this for

interest rate volatility, recording the $LIBOR rate at six-monthly intervals over the period 1980-

95.

-

I flat io $ LIBOR Re al R at e

Figure 1

Time

Rate

Figure 1 also shows the inflation rate that was observed over the subsequent three-month period.

The inflation rate is measured by the consumer price index (CPI) in the United States. The third

line in Figure 1 shows the real interest rate, defined conventionally as follows

Real Interest Rate = $LIBOR - CPI Inflation rate


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The real interest rate is an ex- post measure of the real rate of return earned by investors from

investing $LIBOR for each three-month period, given the inflation that subsequently occurred

over that period.

Figure 2 shows the 3-month LIBOR interest rates in three major currencies, dollar, yen and

pound sterling, during the period 1989-1995. It is evident from the graph that these key rates

have fluctuated considerably in all three currencies. For instance, even over the relatively short

period of six years, the short term interest in Japan has varied between a little under 8% in early

1989 and a little over 0.5 % in late 1995.

Figure 2: Payoff on a Futures Contract

-

.

-

.

.

.

.

.

.

Payoff

Libor

The volatility in short term interest rates is closely related to the volatility of foreign exchange

rates. Figure 3 shows the volatility of certain key foreign exchange rates, against the US dollar,

the yen, the DM and the pound sterling, over the period 1989-1995. For example, the yen has

fluctuated in a range of about two-to-one in the past six years.

The historical volatility of a financial variable is normally measured by the standard deviation of

the observations of the logarithm of the variable, stated on an annualized basis. For example, the


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standard deviation of the six-monthly observations of $LIBOR recorded in Figure 1 on an

annualized basis is

Figure 3: Payoff on an Options Contract

-

.!

.

!

."

.

#

$

.$

.$

!

Pa % of f Ne t Pr o f it

Payoff

Libor

Error! Bookmark not defined.

On a similar basis, the volatility of the inflation rate and the real interest rate are

The volatility of foreign exchange rates can be computed on a similar basis.

Hedging foreign exchange and interest rate risk

The basic ideas underlying the management of foreign exchange and interest risk are

quite similar. First, consider the position of a company that borrows at a rate of $LIBOR + to

finance its operations. The premium, , (above LIBOR) that it has to pay depends upon its credit

status. A large company with a sound balance sheet should be able to borrow, for example, at say

$LIBOR + 1/8. If $LIBOR is 5 1/4 per cent, it would pay 5 3/8 per cent on its borrowings. Such

a firm would have seen its borrowing cost vary considerably over the period shown in Figure 1:

from a minimum of 3 1/4 + 1/8=

3 3/8 per cent in February 1994 to 17 7/8 + 1/8=

18 per cent inJune 1982.

Now, consider the position of an investor who invests a proportion of his or her portfolio in

three-month $Treasury bills (T. Bills), purchasing these bills every three months. Since the price


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of three-month T. Bills closely follows the three-month $LIBOR rate the return on this

investment strategy, net of transaction costs, turns out to be say $LIBOR - 3/4 per cent. Again,

an investor who followed this strategy over the period shown in Figure 1 would have seen a

return varying from a minimum of 3 1/4 - 3/4 = 2 1/2 per cent in February 1994 to 17 7/8 - 3/4 =

17 1/8 per cent in June 1982.

A similar example can be given for the case of foreign exchange risk. Consider a firm that

exports its products at prices denominated in a foreign currency. If the firm does not hedge its

exposure, its export earnings would be very volatile, given the uncertainty of foreign exchange

rates. For example, a company exporting goods worth $1 million would have received 160

million yen for it in mid-1989 and only half as much in mid 1995. Even over the latter half of

1995, the yen/dollar exchange rate has fluctuated between about 80 to over 105 yen to the dollar.

These examples show that foreign exchange and interest rates have varied considerably over

time and are likely to vary in the future. For example, if a firm is committed to capital

expenditures in the future, or has working capital requirements that will need to be financed, it

faces the prospect of uncertain future cash flows, both for capital and operating items.

Similarly, investors face the prospect of uncertain future returns on their investments.

The financial management of foreign exchange and interest rate risk often takes the form of

hedging. Hedging these risks involves placing a bet that pays off when the foreign exchange rate

or interest rate goes against the agent. For example, an appropriate hedge for the borrowing

company in the above example would be to place a bet on the interest rate rising in the future.

The bet will pay off if interest rates rise and the resulting profit would offset, to some extent, the

rise in the firm's borrowing costs. Similarly, a firm exporting goods denominated in a foreign

currency will be able to hedge its foreign currency exposure by selling its foreign currency

inflows with foreign currency forward or options contracts. It is the purpose of foreign currency

and interest rate futures and options markets to provide a simple way of betting on changes in the

foreign exchange and interest rates.

Hedging foreign exchange and interest rate risk: forward and long term loan contracts


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Before considering the use of options and futures markets, we first consider the traditional ways

of hedging foreign exchange and interest rate risk. An extreme form of risk management is to

"lock-in" the foreign exchange and interest rates over the future period. In the case of foreign

exchange risk, this can be done with forward contracts, which can be entered into, either for long

maturities, if possible, or for shorter maturities, but on a "rolling" basis, i.e. a new contract is

purchased just as the previous one expires. For instance, a Japanese firm that regularly buys

crude oil, whose price is usually stated in US dollars, as a raw material, can hedge its foreign

exchange exposure by buying dollars forward. Similarly, a Japanese exporter of goods invoiced

in dollars could hedge its risk by selling dollars forward. The problem with this approach is that

long-term forward contracts were not available until recent years, and even today, are available

only between the major currencies. In the case of foreign exchange contracts, longer-dated

contracts have relatively poor liquidity, compared with the short-dated maturities. Hence, inmany cases, only a rolling hedge is feasible for hedging long-term risks.

In the case of interest rate risk, the equivalent method would be to lock-in the interest rates, again

either over a long horizon or on a rolling basis. Thus, the traditional way of hedging against

changes in the short-term interest rates is to borrow or lend on a long-term contracts at a fixed

rate. For example, a company could issue a 20 year, fixed interest rate bond. On the other side of

the transaction, an individual investor could lend money by buying such a bond. However, two

important problems arise with this type of hedging. First, it may be difficult or costly for the

investor to sell the bond if it turns out that the money is needed for other purposes at some future

date. Second, buying a long term bond involves taking an increased default risk: the risk that the

borrower may not be able to repay the promised capital at the maturity date. Long term loans,

even when made by Governments, tend to require higher rates of interest because of these risks.

This discourages borrowers from raising loans in this manner. Moreover, in a world of uncertain

inflation, a long term, fixed rate loan becomes a highly risky security in terms of real purchasing

power. From the lender's point of view, supposing that the bond promises to pay back $100 in 25

years time, the real purchasing power of this $100 is highly uncertain in an inflationary world.

Long term loans that may be almost riskless in nomin al or money terms are often highly risky in

re al terms.


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Long-term forward contracts and bonds represent the traditional method by which companies,

investors and Governments hedge their future foreign exchange and interest rate exposure.

However, they have to be viewed in relation to other hedging alternatives which offer different

trade-offs of risk versus cost/return. In particular, derivative contracts, broadly defined, provide

a range of possibilities for managing foreign exchange and interest rate risk, as we shall see

below.

Hedging with foreign exchange and interest rate derivatives

A deri va tive security or contract is one whose payoff and value depend upon the price of some

underlying asset. In the present context, we are concerned with foreign exchange and interest rate

derivatives. These are contracts whose payoff and value depend upon an underlying foreignexchange or interest rate (or bond price). The forward contracts, futures contracts and option

contracts mentioned in the overview are all examples of derivatives. One of the main features of

a derivative is that the contract is detachable from the underlying asset. If an agent desires to

speculate on the movement of a future foreign exchange or interest rate, it can use a derivative as

a stand-alone bet. However, if it wishes to hedge an existing borrowing or lending commitment,

it must add the derivative payoff to its loan costs or returns. The market for derivatives allows

hedgers and speculators such as corporations, investors, banks, brokers and other institutions

involved in providing these services to compete in the same market, using the instruments for

whatever purpose they desire. For example, in the case of interest rate risk, the loan cost,

including the payoff from the derivative will be

Net Borrowing

Cost / Lending

Return

= Market

interest rate at

the future date

+ / - Payoff on the

derivative

For example, if a borrower hedges, and interest rates rise, they might end up paying a market rate

of interest of x per cent, having a payoff from the derivative of y percent and a net borrowing


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cost of x- y per cent. A similar definition in terms of costs/prices in terms of domestic currency

can be made in the case of foreign exchange derivatives.

Hedging with futures/forward and options contracts

F orw a rd contracts have been common in commodity and foreign exchange markets for

centuries. In the middle ages, for example, the monks from the abbeys in Yorkshire, England,

bought their wool forward on continental markets. Forward and futures contracts on rice

warehouse receipts were traded in Japan since the later seventeenth century. Forward contracts

to buy and sell commodities, foreign exchange and interest rate instruments are in widespread

use today and are growing at a rapid rate. Indeed, much of the trading in foreign exchange even

today is in the form of forward and swap contracts, and currently is about one trillion dollars aday. However, public futures markets have evolved to overcome some of the moral hazard

problems associated with forward markets (i.e. the incentive for one of the parties to the contract

to default on the contract). Futures contracts are made between a hedger and the cl ea ring

cor por a tion of a f u t u res exch a nge . Also, the default risk problem is minimized by requiring the

contract holder to put up margin; a form of deposit against adverse price movements. Futures

contracts are also of a standard size. For example, in the case of short term interest rate futures,

one standard Eurodollar futures contract represents a bet on the future short term (3-month)

interest rate on a face amount of one million dollars. Note that the holder of a l ong futures

contract receives the difference between the market rate of interest and the futures rate agreed in

the contract. The holder of a short futures contract pays the difference between the market

interest rate and the agreed futures rate. Note that a forward or futures contract has no up-front

cost i.e., at the time the contract is made, so that it is initially a zero-value contract. In the case

of futures contracts, the marking-to-market ensures that the contract has zero value at the end of

each trading day.

In contrast, an o ption contract can be thought of as a one-sided futures contract. For example, a

call option on the Deutsche Mark confers the right but not the obligation on the holder to

exchange dollars for marks at a prescribed exchange rate.


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The difference between the payoffs on the futures and the option contract are illustrated by the

examples shown in Figures 4 and 5 respectively. It is simply an agreement to buy or sell in the

future. In Figure 4, this is indicated by the horizontal line on the LIBOR axis. The payoff on the

long futures is the difference between the LIBOR rate and 0.06 (6%), the assumed futures rate. If

LIBOR rises to 0.064 (6.4%), a profit of 0.004 (40 basis points) is made, but if LIBOR falls to

0.056 (5.6%), a loss of 0.004 (40 basis points) is made. In the case of the call option contract,

however, as shown in Figure 5, a positive payoff is received if LIBOR rises, but the payoff is

zero if LIBOR falls. Since the option payoff can only be non-negative, the call option contract

must have a positive price. In other words, it must cost money to enter the options contract. This

entry price is called the option premium. In Figure 5 we assume the premium is 0.002 (20 basis

points). Then, the dashed line in Figure 5 indicates the net profit, i.e. [payoff - premium], from

the contract. Similar examples can be constructed for the case of foreign exchange risk.

Foreign exchange and interest rate risk can be hedged either by entering into a futures contract or

an option contract. The difference is that the purchase of an appropriate number of the futures

contracts can result in the borrower or lender completely fixing the rate to be paid or received in

the future. On the other hand, the option contract is more akin to an insurance contract. It

protects the borrower, for example, against an increase in rates in return for an insurance

premium. However if rates fall, he or she can still benefit from lower market rates. In Figure 5,

for example, with an interest rate option, the maximum interest rate is capped at 0.062, but when

interest rates go down, the borrower gets the benefit.

Hedging foreign exchange and interest rate risk with forward contracts


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Firms and other large organizations often hedge their foreign exchange and interest rate exposure

by making forward contracts directly with dealers, mainly banks, rather than by using publicly-

traded futures contracts. The market where these contracts with banks are arranged is referred to

as the over-the-counter (OTC) market. The two most important contracts in this market are

forwa rd contr a cts and foreign c u rrency swa p s in the case of foreign exchange rates and forwa rd

r a te a greements (FRA's) and the swa p s for interest rates.

A foreign exchange forward contract is an agreement to receive the difference (positive or

negative) between the foreign exchange rate, say between US dollars and Deutsche Marks, on a

given future date, and a pre-set fixed rate, based on a given face amount. A foreign currency

swap is a series of FRA's covering several future dates.

FOREIGN EXCHANGE POLICY

I. Purpose:

The purpose of this document is to establish ( na me of comp any) policy for the management of

corporate foreign exchange risk by defining its exposures, measuring them, and defining

appropriate actions to control the risk. Furthermore, the intent of this Policy is to minimize the

income statement impact of fluctuating foreign currency exchange rates.

II. Definitions:

Economic Exposure: is the change between anticipated net cash flow in currencies other than

the US Dollar and the actual results that are entered on the company's consolidated financial

statements. Economic exposures would indicate anticipated accounts receivable and accounts

payable that are not priced in US Dollars, with respect to which the Company cannot adjust the

pricing or costs in time to eliminate an exchange gain/loss. In essence, economic risk concerns


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the impact that exchange rates can have on future operations. The most visible example of this

type of exposure to the Company is in its reporting of international operations against plan. The

international business plans are based on currency values that are not the same as used in

measuring actual results. A stronger US Dollar than plan will reduce revenues and expenses

while a weaker Dollar will have the opposite effect.

Economic exposure also occurs for exposures that are contingent in nature, such as product

acceptance based on performance criteria. Foreign exchange risk from economic exposure

occurs:

y During the period between the delivery of a proposal and the signing of the contract

y Between the signing of a contract and revenue recognition

Accounting Exposure: exists in two types (transactional and translation) with differing impacts

on the financial statements of the Company:

Transaction Exposure (1): is the net cash flow in currencies other than the US Dollar between

the time the transaction is entered on the Company's financial statements and the time the actual

cash payment is made.

This exposure also occurs when:

The Company's subsidiaries have monetary assets or liabilities in a currency other than their

local currency. Both revaluation and settlement of these accounts will result in an FX gain or

loss, which will be recorded to the income statement.

Translation Exposure (2): occurs by the need to convert foreign currency financial statements

into US Dollars for consolidation purposes. The conversion from local currency to the USD for

subsidiaries whose functional currency is the US Dollar results in exchange gains and losses

(translation adjustments) that are included in income.


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The conversion for subsidiaries whose functional currency is their local currency results in

translation adjustments that are recorded to equity.

Functional Currency: is an accounting term that is outlined in Financial Accounting Standard

52 and defines the currency in which an entity's financial statements shall be measured before

being restated into US Dollars.

III. Policy:

The Company will enter into foreign exchange contracts with the objective to protect its financial

performance from the adverse effects of foreign currency fluctuations. Transaction exposure is

clearly definable and can be measured by the outstanding nonfunctional currency assets andliabilities on the balance sheet at any statement date; therefore, with regard to transactional

exposure, no foreign currency contracts of any kind will be entered into without an associated

underlying foreign currency exposure. It is the Policy of the Company to maintain up to a fully

hedged position with respect to transaction exposure.

The Company is exposed to economic risk resulting from future transactions denominated in

foreign currency that are highly probable to occur but that are not reflected on the financial

statements of the company until the transactions are firmly agreed and legally binding. The

Company will regularly measure the potential effects of economic exposure on its performance

and report it to management. It is the Company's Policy to not maintain any hedged position with

respect to economic exposure at the present time. However, the Company shall regularly advise

the board on the Companys economic exposure and shall recommend hedging strategies for

approval should the situation warrant, as set forth under section IV.

For foreign subsidiaries, the Company will not hedge translation exposure. From time to time,

however, it may be in the Companys interest to protect the total equity value of the firm,

including its overseas investments. In those circumstances, the company shall recommend to the

board hedging local currency functional subsidiaries net equity exposure. Approval shall be

sought as described under the guidelines set forth under section IV.


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Under no circumstances will the company enter into purely speculative foreign exchange

contracts for trading purposes that cannot be related to its transactional, economic, or

translational exposures as defined above.

The Foreign Exchange Policy will be generally implemented, reviewed, and monitored by the

Investment Review Committee, which shall consist of the Chief Executive Officer,

Chief Financial Officer and the Treasurer.

The Company will generally use forward contracts to cover exposures. Under certain

circumstances, other derivative instruments such as purchased options and zero cost option

combinations (limited to Range Forwards, Participating Forwards, and Forward Extras) may bedesirable for their specific risk mitigation properties. The Company will be authorized to use

these instruments in conjunction only with the responsibilities outlined in section IV. The

maturity of a hedging instrument shall be no longer than one year.

IV. Structure, Responsibility and Authority:

A. Responsibilities of the Chief Financial Officer

The CFO has the following responsibilities with respect to the management of the

Company's foreign exchange exposure:

y Review and approval of the Company's foreign exchange Policy.

y Review, with the Investment Committee, of each foreign exchange position and monthly

reports, for foreign exchange.

y Advance approval of foreign exchange transactions that are not consistent with the

guidelines prescribed in this Policy.

B. Responsibilities of the Treasurer

The Treasurer has the following responsibilities with respect to the management of the


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Company's foreign exchange exposure:

y Review and approval of the Company's foreign exchange Policy.

y Approval of all relationships with banks and other financial institutions for the purpose of

conducting foreign exchange business.

y Review of each foreign exchange position and monthly reports, for foreign exchange

Policy compliance and performance.

y Conduct regular reviews of foreign exchange positions

y Recommend appropriate hedging strategies and instruments

y Execute foreign exchange activity, which has been authorized and approved by the

Company, including buying and selling foreign exchange spot, forward, and option

contracts and executing wire transfers.

y Preparation of the reports specified in this Foreign Exchange Policy for management

review.

The Treasurer will implement control systems and procedures that provide for an appropriate

level of segregation of duties related to the conduct of, and accounting for, foreign exchange

activity.

V. Reporting:

A. Report Contents

The Treasurer will prepare a monthly Foreign Exchange Report on accounting exposures that

contains the following information:

y The net transaction exposure of the Company, by currency, and recommendations of

appropriate hedging actions.

y The number of transactions (contract purchases and sales) made during the month.

y A summary of the current open foreign exchange contract and explanation of the strategy

behind the open positions.

y The net results of positions that have been closed during the month.


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y The reasons for, and amounts of, violations of (or exceptions to) the Foreign Exchange

Policy during the month.

y The status of any foreign exchange positions that might require management attention.

The Foreign Exchange Report will contain information with respect to all transactions occurring

during the month, whether or not they have been fully settled as of the end of the month.

The Foreign Exchange Report will contain a management summary that will describe the status

of the hedged positions and significant transactions made during the previous month. The

management summary should be presented in a manner that will allow the CFO and the

Controller to determine whether foreign exchange activity during the month has adhered to the

Company's Foreign Exchange Policy.

The Treasurer will prepare a quarterly report that measures economic exposure to foreign

exchange risk. The measurement of economic exposure will consist of the foreign currency

components of forecasted revenue, allocated operating expenses, and acquisitions.

B. Report Distribution

The monthly Foreign Exchange Report will be distributed to the Chief Financial Officer and the

Controller.

VI. Internal Controls:

The Treasurer is responsible for recommending, and the CFO is responsible for approving, all

hedging strategies. Only the CFO, the Controller, and the Treasurer shall have the authority to

enter into foreign exchange contracts that will provide foreign exchange coverage. The Treasurer

is responsible for implementing internal control procedures and ensuring that procedures are

followed.


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Once the CFO has approved a hedging strategy, the Treasurer shall be authorized to execute the

contracts with an approved bank. The following procedures shall be followed:

1. The Treasurer will record all transactions on the FX Contract Log immediately upon

execution. The CFO will approve all contracts recorded on the FX Contract Log within two days

of execution. The aggregate amounts of hedge contracts should not deviate from the approved

level.

2. Bank confirmations of foreign exchange transactions will be sent directly to the Controller.

The Controller will crosscheck the confirmations against the FX Contract Log. If the

confirmation has not been received within 10 working days after the execution date of the

contract, the Controller will personally contact the FX desk at the bank to verify that the trade isindeed reflected on the bank's records, and to request a confirmation in writing. If there is a

discrepancy, the Controller will personally contact both the Foreign Exchange trader at the bank

and the Treasurer to determine whose records are in error. The CFO shall be notified when any

problems occur.

3. At the end of the month, the Controller, or an appropriately designated person, shall review all

incoming and outgoing cash transfers pertaining to Foreign Exchange. The Controller shall

ensure that the appropriate amounts were received/paid on the appropriate dates. Specifically,

cash transfers related to FX contracts should be reconciled with the FX Contract Log, and

supported by copies of the confirmations. The same procedure shall be performed at the end of

each month, for the entry supporting unrealized gains/losses on open FX contracts.

A. Qualification of Financial Institution

The bank authorized to conduct foreign exchange business with the Company will, if based in

the US, be a member of the Federal Deposit Insurance Corporation (FDIC).

B. Notice to FX Advisor


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The financial institution conducting foreign exchange business with the Company shall receive

the following information and documents:

y A copy of the Company's Foreign Exchange Policy

y A letter signed by the CFO describing the relationship that the Company is establishing

with the financial institution. This letter will contain the information shown below:

o Confirmation that at least two authorities are required to execute any transaction.

o Company employees who are authorized to buy and sell foreign currency on

behalf of the Company.

o Company employees who are authorized to wire or otherwise transfer funds out of

the Company accounts.

o Company employees who are authorized to make changes to the Company's

instructions regarding authority, delivery instructions, or other critical aspects of

the relationship.

o Company employees who should be notified if the financial institution detects any

activity that it believes may be irregular given its understanding of the Company's

Foreign Exchange Policy and practices.

o Standard delivery instructions for proceeds from forward contracts.

The financial institution will be notified immediately, both verbally and in writing, with respect

to the change in status of any employee authorized to conduct foreign exchange business with

that institution.

VII. Review of Foreign Exchange Management:

A. Policy Expectations

This Policy provides guidelines for the management of the foreign exchange hedging. Under

some circumstances, foreign exchange transactions that are appropriate for the Company, and

entirely within the spirit of this Foreign Exchange Policy, may not fall within the prescribed

quantitative guidelines contained in this Foreign Exchange Policy. When the Treasurer


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determines that a foreign exchange transaction is in the best interest of the Company and is

consistent with the objectives of this Foreign Exchange Policy, the transaction is permitted even

though it is not consistent with the quantitative guidelines, subject to the following controls.

Whenever a transaction that is an exception to the quantitative guidelines is made, the

CFO will approve it in writing prior to the transaction being executed. If the Policy is breached

inadvertently, the CFO will be notified immediately.

B. Policy Review

This Foreign Exchange Policy will be reviewed annually to ensure that it remains consistent with

the overall objectives of the Company and with current financial trends. The Policy may be

reviewed and updated more frequently if conditions dictate. Proposed amendments to the Policyshould be prepared by the Treasurer, and should be reviewed and ratified by the Chief Financial

Officer.

Rupee Dollar Enigma

There is a lot of discuss in India on the rupee dollar rate and on RBIs foreign exchange

reserves, as measured in dollars. However, the dollar is not a stable yardstick. The dollar hasitself been fluctuating quite a bit. We should be careful not to read too much in changes in the

rupee-dollar rate or in the level of reserves which merely reflect fluctuations of the dollar.

For example from April 2006 till the end of October 2008 shows a depreciation of the

rupee from roughly 40 to the dollar in early 2008, first to 42 and then a much sharper movement

to 50 rupees. What was going on?

Many people think that in the global financial crisis, FII and other capital left the country,

thus giving a sharp depreciation. This picture is mostly wrong. In order to get a better sense of

what is going on, we turn to the Major Currencies Index maintained by the US Federal

Reserve. This is an index of the movements of the US dollar against the major floating exchange

rates of the world. This index, which is abbreviated USM, shows gradual dollar depreciation


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from the index level of 85 to 70 through 2007. In recent months, it shows a sharp appreciation of

the dollar. The entire dollar depreciation of recent years has been reserved in a few weeks.

What has been going on is a flight to quality. In the global financial crisis, US and other

investors are selling off many risky assets all over the world and shifting money back to US

government bonds. This has given a sharp appreciation of the dollar and a decline in interest

rates of US government bonds.

A good part of the recent rupee depreciation, then, is merely a dollar appreciation. It isnt

as if conditions in India changed that much; it was the yardstick (the US dollar) that shifted. To

help clarify our minds, it is useful to re-express the fluctuations of the rupee in terms of the

USM. This reflects the evolution of the rupee when expressed in the major floating exchangerates of the world.

CURRENCY

The big hotels, shops, restaurants and various Indian Airlines take major international

credit cards. Travelers cheques are the safest form of money to be carried, and can be used

directly to settle bills. Stick to the well known brands American Express, Visa, Thomas Cook,

Citibank and Barclays, keep the photocopies too. The best currencies to take are US dollars andPound sterling. More than $10,000 (or equivalent) in cash, must be declared.

There are also 24 hour branches of the State Bank of India and Thomas Cook in the arrival and

departure areas of the international airport.

The Indian currency is the rupee (Rs), which has 100 paisa. There are coins of 25, 50 paise and

also coins of Rs. 1, 2, 5. There are notes of Rs. 1, 2, 5, 10, 20, 50, 100 and 500.

Foreigners will get encashment certificates from the Bank for each transaction, which should be

kept carefully. In case, while going back they want the Indian Rupees to be changed back into

foreign currency, the same can be done upto US $ 500 worth of rupees. Credit cards are widely

accepted at mid range and upmarket hotels and for buying rail and air tickets and also in many

shops. On a MasterCard, Visa Card, or Japanese Credit bureau card, they can now get cash


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advances in rupees on the spot in main cities. With American Express they can get dollar or

sterling travellers cheques in Delhi.

Major Financial Institutions in India

This is a list on the major financial institutions in India and their respective date

of starting operations.

Financial Institution Date of Starting

Imperial Bank of India 1921

Reserve Bank of India April 1, 1935Industrial Finance corporation of India 1948

State Bank of India July 1, 1955

Unit Trust of India Feb. 1,1964

IDBI July 1964

NABARD July 12,1982

SIDBI 1990

EXIM Bank January 1, 1982

National Housing Bank July 1988

Life Insurance Corporation (LIC) September 1956

General Insurance Corporation (GIC) November 1972

Regional Rural Banks Oct. 2, 1975

Risk Capital and Technology Finance Corporation Ltd. March 1975

Technology Development & Information Co. of India Ltd. 1989

Infrastructure Leasing & Financial Services Ltd. 1988

Housing Development Finance Corporation Ltd. (HDFC) 1977


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WHY FOREIGN EXCHANGE

In a universe with a single currency, there would be no foreign exchange market, no

foreign exchange rates, no foreign exchange. But in our world of mainly national currencies, the

foreign exchange market plays the indispensable role of providing the essential machinery for

making payments across borders, transferring funds and purchasing power from one currency to

another, and determining that singularly important price, the exchange rate. Over the past

twenty-five years, the way the market has performed those tasks has changed enormously.

HOW THE GLOBAL ENVIRONMENT HAS CHANGED

Since the early 1970s, with increasing internationalization of financial transactions, the

foreign exchange market has been profoundly transformed, not only in size, but in coverage,

architecture, and mode of operation. That transformation is the result of structural shifts in the

world economy and in the international financial system. Among the major developments that

have occurred in the global financial environment are the following:

A basic change in the international monetary system, from the fixed exchange rate

par value requirements of Bretton Woods that existed until the early 1970s to the flexible legalstructure of today, in which nations can choose to float their exchange rates or to follow other

exchange rate regimes and practices of their choice.

A tidal wave of financial deregulation throughout the world, with massive

elimination of government controls and restrictions in nearly all countries, resulting in greater

freedom for national and international financial transactions, and in greatly increased

competition among financial institutions, both within and across national borders.

A fundamental move toward institutionalization and internationalization of savings

and investment, with funds managers and institutions around the globe having vastly larger

sums available, which they are investing and diversifying across borders and currencies in novel

ways and in ever larger amounts as they seek to maximize returns.


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A broadening and deepening trend toward international trade liberalization, within

a framework of multilateral trade agreements, such as the Tokyo and the Uruguay Rounds of

the General Agreement on Tariffs and Trade, the North American Free Trade Agreement, and

U.S. bilateral trade initiatives with China, Japan, and the European Union.

Major advances in technology, making possible instantaneous real-time transmission of

vast amounts of market information worldwide, immediate and sophisticated manipulation of

that information to identify and exploit market opportunities, and rapid and reliable execution of

financial transactionsall occurring with a level of efficiency and reduced costs not dreamed

possible a generation earlier.

Breakthr ou ghs i n the the ory and pract i ce of fi nance , resulting not only in the

development of innovative new financial instruments and derivative products, but also in

advances in thinking that have changed our understanding of the financial system and our

techniques for operating within it. The common theme underlying all of these developments is

the role of marketsthe growth and development of markets, enhanced freedom and

competition in markets, improvements in the efficiency of markets, increased reliance on market

forces and mechanisms, and the creation of better market techniques and instruments. The

interplay of these forces, feeding off each other in a dynamic and synergistic way, created a

global environment of creativity and ferment. In the 1970s, exchange rates became more volatile

and imbalances in international payments grew much larger for well-known reasons: the advent

of a floating exchange rate system, deregulation, and major macroeconomic shifts in the world

economy. That caused financing needs to expand, whichat a time of rapid technological

advanceprovided fertile ground for the development of new financial products and

mechanisms. These innovations helped market participants circumvent existing controls and

encouraged further moves toward deregulation, which led to additional new products, facilitated

the financing of still larger imbalances, and encouraged a trend toward institutionalization of

savings and diversification of investment. Financial markets grew progressively larger and more

sophisticated, integrated, and efficient. In that environment, foreign exchange trading increased

rapidly and changed intrinsically. The market has expanded from one of banks to one in which


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many other kinds of financial and non-financial institutions also participate including

nonfinancial corporations, investment firms, pension funds, and hedge funds. Its focus has

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