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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