9.

2 STRATEGIC FINANCIAL MANAGEMENT

9
In consonance with these remarkable changes, the Government of India has also opened Indian
economy to foreign investments and has taken a number of bold and drastic measures to globalise
the Indian economy. Various fiscal, trade and industrial policy decisions have been taken and new
avenues provided to foreign investors like Foreign Institutional Investors (FII's) and NRI's etc., for
investment especially in infrastructural sectors like power and telecommunication etc.
The basic principles of financial management i.e., efficient allocation of resources and raising of

FOREIGN EXCHANGE EXPOSURE funds on most favourable terms and conditions etc. are the same, both for domestic and
international enterprises. However the difference lies in the environment in which these multi-

AND RISK MANAGEMENT

national organisations function. The environment relates to political risks, Government's tax and
investment policies, foreign exchange risks and sources of finance etc. These are some of the
crucial issues which need to be considered in the effective management of international financial
transactions and investment decisions.

LEARNING OUTCOMES Under the changing circumstances as outlined above, a finance manager, naturally cannot just be
a silent spectator and wait and watch the developments. He has to search for "best price" in a
After going through the chapter student shall be able to understand global market place (environment) through various tools and techniques. Sometimes he uses
currency and other hedges to optimise the utilisation of financial resources at his command.
 Exchange rate determination
However, the problems to be faced by him in the perspective of financial management of the
 Foreign currency market multinational organisations are slightly more complex than those of domestic organisations. While
 Management of transaction, translation and economic exposures the concepts developed earlier in the previous chapters are also applicable here, the environment
in which decisions are made in respect of international financial management is different and it
 Hedging currency risk forms the subject matter of this chapter for discussion. In this chapter we shall describe how a
 Foreign exchange derivatives – Forward, futures, options and finance manager can protect his organisation from the vagaries of international financial
transactions.
swaps
2. NOSTRO, VOSTRO AND LORO ACCOUNTS
1. INTRODUCTION In interbank transactions, foreign exchange is transferred from one account to another account
Coupled with globalisation of business, the raising of capital from the international capital markets and from one centre to another centre. Therefore, the banks maintain three types of current
has assumed significant proportion during the recent years. The volume of finance raised from accounts in order to facilitate quick transfer of funds in different currencies. These accounts are
international capital market is steadily increasing over a period of years, across the national Nostro, Vostro and Loro accounts meaning “our”, “your” and “their”. A bank’s foreign currency
boundaries. Every day new institutions are emerging on the international financial scenario and account maintained by the bank in a foreign country and in the home currency of that country is
introducing new derivative financial instruments (products) to cater to the requirements of known as Nostro Account or “our account with you”. For example, An Indian bank’s Swiss franc
multinational organisations and the foreign investors. account with a bank in Switzerland. Vostro account is the local currency account maintained by a
foreign bank/branch. It is also called “your account with us”. For example, Indian rupee account
To accommodate the underlying demands of investors and capital raisers, financial institutions and
maintained by a bank in Switzerland with a bank in India. The Loro account is an account wherein
instruments have also changed dramatically. Financial deregulation, first in the United States and
a bank remits funds in foreign currency to another bank for credit to an account of a third bank.
then in Europe and Asia, has prompted increased integration of world financial markets. As a
result of the rapidly changing scenario, the finance manager today has to be global in his
approach.
 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT 79.3 9.4 STRATEGIC FINANCIAL MANAGEMENT

2.1 Exchange Position TT Remittance 37,500

It is referred to total of purchases or sale of commitment of a bank to purchase or sale foreign Draft on London cancelled 15,000 —
exchange whether actual delivery has taken place or not. In other words all transactions for which 1,02,500 82,500
bank has agreed with counter party are entered into exchange position on the date of the contract. Closing Balance Overbougt — 20,000
2.2 Cash Position 1,02,500 1,02,500

it is outstanding balance (debit or credit) in bank’s Nostro account. Since all foreign exchange Cash Position (Nostro A/c)
dealings of bank are routed through Nostro account it is credited for all purchases and debited for
Credit £ Debit £
sale by bank.
Opening balance credit 65,000 —
It should however be noted that all dealings whether delivery has taken place or not effects the
TT Remittance — 37,500
Exchange Position but Cash Position is effected only when actual delivery has taken place.
65,000 37,500
Therefore, all transactions effecting Cash position will affect Exchange Position not vice versa.
Closing balance (credit) — 27,500
Illustration 1 65,000 65,000
Suppose you are a dealer of ABC Bank and on 20.10.2014 you found that balance in your Nostro
To maintain Cash Balance in Nostro Account at £7,500 you have to sell £20,000 in Spot which will
account with XYZ Bank in London is £65,000 and you had overbought £35,000. During the day
bring Overbought exchange position to Nil. Since bank require Overbought position of £7,500 it
following transaction have taken place:
has to buy the same in forward market.
£
DD purchased 12,500 3. EXCHANGE RATE QUOTATION
Purchased a Bill on London 40,000 3.1 American Term and European Term
Sold forward TT 30,000
Quotes in American terms are the rates quoted in amounts of U.S. dollar per unit of foreign
Forward purchase contract cancelled 15,000
currency. While rates quoted in amounts of foreign currency per U.S. dollar are known as quotes in
Remitted by TT 37,500 European terms.
Draft on London cancelled 15,000
For example, U.S. dollar 0.2 per unit of Indian rupee is an American quote while INR 44.92 per unit
What steps would you take, if you are required to maintain a credit Balance of £7,500 in the Nostro of U.S. dollar is a European quote.
A/c and keep as overbought position on £7,500? Most foreign currencies in the world are quoted in terms of the number of units of foreign currency
Solution needed to buy one U.S. dollar i.e. the European term.
Exchange Position: 3.2 Direct and Indirect Quote
Particulars Purchase £ Sale £ As indicated earlier, a currency quotation is the price of a currency in terms of another currency.
Opening Balance Overbought 35,000 — For example, $1 = `48.00, means that one dollar can be exchanged for `48.00. Alternatively; we
may pay `48.00 to buy one dollar. A foreign exchange quotation can be either a direct quotation
DD Purchased 12,500 —
and or an indirect quotation, depending upon the home currency of the person concerned.
Purchased a Bill on London 40,000 —
A direct quote is the home currency price of one unit foreign currency. Thus, in the aforesaid
Sold forward TT — 30,000
example, the quote $1 =`48.00 is a direct-quote for an Indian.
Forward purchase contract cancelled — 15,000
 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT 79.5 9.6 STRATEGIC FINANCIAL MANAGEMENT

An indirect quote is the foreign currency price of one unit of the home currency. The quote Re.1 bid/offer quote). When the first dealer is happy with the ‘ask’ price given by the second dealer,
=$0.0208 is an indirect quote for an Indian. ($1/` 48.00 =$0.0208 approximately) he/she would convey “ONE MINE”, which means “I am buying one million dollars from you”. If the
first dealer had actually wanted to sell one million dollars and had asked a quote, and he is happy
Direct and indirect quotes are reciprocals of each other, which can be mathematically expressed
with the ‘bid’ price given by the second dealer, he/she would convey “ONE YOURS”, which means
as follows.
“I am selling one million dollars to you”.
Direct quote = 1/indirect quote and vice versa
3.4 Cross Rates
The following table is an extract from the Bloomberg website showing the Foreign Exchange Cross
rates prevailing on 14/09/2012. It is the exchange rate which is expressed by a pair of currency in which none of the currencies is
the official currency of the country in which it is quoted. For example, if the currency exchange rate
USD CNY JPY HKD INR
KRW SGD EUR between a Canadian dollar and a British pound is quoted in Indian newspapers, then this would be
USD – 0.1583 0.0128 0.129 0.0184
0.0009 0.8197 1.3089 called a cross rate since none of the currencies of this pair is of Indian rupee.
CNY 6.3162 – 0.0809 0.8147 0.1161
0.0057 5.177 8.2667 Broadly, it can be stated that the exchange rates expressed by any currency pair that does not
JPY 78.08 12.362 – 10.072 1.435
0.0701 64 102.17 involve the U.S. dollar are called cross rates. This means that the exchange rate of the currency
HKD 7.7526 1.2274 0.0993 – 0.143
0.0069 6.3546 10.148 pair of Canadian dollar and British pound will be called a cross rate irrespective of the country in
INR 54.405 8.613 0.6955 7.005 – 0.0488 44.505 71.067 which it is being quoted as it does not have U.S. dollar as one of the currencies.
KRW 1,114.65 176.5476 14.2965 143.9908 20.4965 – 914.8582 1,459.05 3.5 Pips
SGD 1.2202 0.1932 0.0156 0.1574 0.0224 0.0011 – 1.5961
This is another technical term used in the market. PIP is the Price Interest Point. It is the smallest
EUR 0.7642 0.121 0.0098 0.0986 0.014 0.0007 0.6263 – unit by which a currency quotation can change. E.g., USD/INR quoted to a customer is INR 61.75.
Source :http://www.bloomberg.com/markets/currencies/cross-rates/ The minimum value this rate can change is either INR 61.74 or INR 61.76. In other words, for
Students will notice that the rates given in the rows are direct quotes for each of the currencies USD/INR quote, the pip value is0.01. Pip in foreign currency quotation is similar to the tick size in
listed in the first column and the rates given in the columns are the indirect quotes for the share quotations. However, in Indian interbank market, USD-INR rate is quoted upto 4 decimal
currencies listed in the first row. Students can also verify that in every case above point. Hence minimum value change will be to the tune of 0.0001. Spot EUR/USD is quoted at a
bid price of 1.0213 and an ask price of 1.0219. The difference is USD 0.0006 equal to 6 “pips”.
3.3 Bid, Offer and Spread
3.6 Forward exchange rate quotation
A foreign exchange quotes are two-way quotes, expressed as a 'bid' and an offer' (or ask) price.
Bid is the price at which the dealer is willing to buy another currency. The offer is the rate at which Forward contract or outright forward contractor merely outright is an agreement between two
he is willing to sell another currency. Thus a bid in one currency is simultaneously an offer in counterparts to exchange currencies on a future date at a rate fixed in the contract. Ideally, the
another currency. For example, a dealer may quote Indian rupees as `48.80 - 48.90 vis-a-vis wayin which exchange rate for a forward date [forward exchange rate] is quoted should be the
dollar. That means that he is willing to buy dollars at `48.80/$ (sell rupees and buy dollars), while same as that for spot date e.g. if the spot rate is 61.53/54, then the [say six months] forward rate
he will sell dollar at ` 48.90/$ (buy rupees and sell dollars). The difference between the bid and quoting should look like say 61.93/98. However, the market convention is different. Forward rate is
the offer is called the spread. The offer is always higher than the bid as inter-bank dealers make not quoted as so and so exchange rate like this but always quoted with spot rate and the forward
money by buying at the bid and selling at the offer. margin separately. In other words, forward quote is not a foreign exchange rate quotation but is
quoted as a difference between spot & forward rates.
Bid - Offer
% Spread = × 100 The reader or user has to calculate the forward applicable rate by loading the forward margin into
Bid
It must be clearly understood that while a dealer buys a currency, he at the same time is selling the spot rate. Thus e.g. in the above case, the foreign exchange dealer will quote the six month
another currency. When a dealer wants to buy a currency, he/she will ask the other dealer a quote forward rate as 40/44. He will even presume that the ongoing spot rate is known to the
for say a million dollars. The second dealer does not know whether the first dealer is interested in counterparty and may not even mention. Even if he were to mention, he will mention only 53/54,
buying or selling one million dollars. The second dealer would then give a two way quote (a because the ‘big figure’ [in this case, “61”] is supposed to be known to the counterparty without
ambiguity. Since the rate fluctuation is very high, the dealer has no time to quote rates in very
 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT 79.7 9.8 STRATEGIC FINANCIAL MANAGEMENT

detailed English sentences and these conventions have come into practice! The numbers 40 & 44 This is because the uncertainty and the liquidity concerns increase as we go forward in time. If we
are arrived at as the differential between 61.93 – 61.53 and 61.98 – 62.54 respectively. These add 5/8 to the left and right side, the spread will widen and hence fits into the argument.
numbers 40 & 44 are called forward margins representing the factor by which the forward rate is
Hence a quote such as 5/8 or 43/45 with increasing numbers from left to right means the foreign
different from the spot rate i.e. the margin to be ‘loaded’ onto the spot rate. Though looks silly, it is
currency is at premium. This looks like a workaround to calculate but the reader can visualize the
worth reiterating that this margin is not the profit margin of the trader!
logic.
If the price on a future date is higher, then the currency is said to be at forward premium and then
Forward points are equivalent to pips in the spot market which we discussed earlier. They are
the number represents the forward premium for that forward period. If the price on a future date is
quoted to an accuracy of 1/100thof one point. E.g. if EUR/USD rates for spot and forward are
lower, then the currency is said to be at forward discount and then the number represents the
1.1323 & 1.1328, then the forward point is 5 because one pip or point is worth 0.0001 in
forward discount for that forward period. In the above example, US dollar is at a premium and the
EUR/USD.
forward premium of USD for six months is 40/44 paise for buying and selling rate respectively in
the interbank market. Generally, the margin is quoted in annualized percentage terms. E.g. in this 3.8 Broken period forward rate
case, extrapolating the premium of six months to twelve months, it can be said that US dollar is
Interbank exchange rates are wholesale rates which are applicable to transaction among banks
likely to have a premium of 80 paise per year [40 paise per six months X 2] which means on a
and in the interbank market. They are for large standard amounts with standardized due dates i.e.
base rate of 61.53, the annualized premium [=0.8*2*100/61.53] is 2.60% p.a. In market parlance,
end of January, end of February and so on. However, in customer transactions, the amounts are
forward premium is quoted in percentage terms and this is the basis of calculation. Actually, the
not only smaller & for odd amounts, but the due date could be also a non standardized one. There
forward market in foreign exchange is an interest rate market and is not a foreign exchange
could be an export bill for euro 12,345.67 getting realized on 10thJanuary or 23rdFebruary and so
market. Because it compares interest rate of one currency with that of another over a period of
on. Thus the forward rate that is available in the interbank market [in the form of forward points for
time. In fact some banks include FX forward traders under their interest rate segment rather than
February, for March and so on] cannot be applied as such for customer transactions. The broken
FX segment.
period concept becomes relevant in such situations.
3.7 Forward point determination On 1stJanuary, if the spot rate for US Dollar is 62 and if the forward margin for two months is 10
The number of ‘basis points’ from the spot rate to arrive at the forward rate in the above paise [premium], then the forward rate can be calculated as ` 62.10 per USD and any customer
discussions is also referred to as forward points. The points are added to the spot rate when the transaction exchange rate can be calculated using this as the base rate. Thus if the bank wishes to
[foreign] currency is at a premium and deducted from the spot rate when the [foreign] currency is keep a margin of say 3 paise, it will quote a rate of ` 62.13 for an importer and quote a rate of `
at a discount, to arrive at the forward rate. This is when the rates are quoted in direct method. In 62.07 for an exporter for an end February realizing bill. However, this logic is valid only for a bill to
case of indirect rate quotations, the process will be exactly the opposite. The forward point may be be realized [for an exporter] or a bill to be paid [for an importer] on 28 thFebruary because the
positive or negative and marked accordingly or specifically mentioned so. The forward points underlying forward rate was for two months on 1stJanuary i.e. the date of 28thFebruary. However,
represent the interest rate differential between the two currencies. E.g. if the spot exchange rate is in customer transactions, the event [of converting FC into INR or vice versa] does not always
GBP 1 = 1.6000 - 1.6010 USD and if the outright forward points are 5-8, then the outright forward happen on the exact standard dates. Thus if the bill is getting paid or is to be retired on
exchange rate quote is GBP 1 = $ 1.6005 - 1.6018. The number of forward points between the 23rdFebruary, then the forward points are to be calculated for such odd number of days starting
spot and forward is influenced by the present and forward interest rates, the ‘length’ of the forward from 1stJanuary. It will be presumed [though there is no logical answer, in practice, it turns out to
and other market factors. Forward point is not a rate but a difference in the rate! Between two be adequately accurate], that the forward points ‘grow’ uniformly throughout and arithmetical
currencies, the currency which carries lower interest rate is always at a premium versus the other proportionate for the applicable date is arrived at. E.g. in the above instance, on 1stJanuary, the
currency. This is the same as stating that if a currency has a relatively higher ‘yield’, then it will premium for a customer transaction expected to happen on 23rdFebruary is calculated as
cost less in the forward market and a currency having lower yield will cost more in the forward =10*53/59 = 8.98 paise [53 & 59 are broken & full periods] and hence the exchange rate will be
market. If there is an aberration to this, arbitration opportunity arises, which itself will push the 62.0898. As market convention, this will be rounded off to 62.09. The merchant forward rate for a
prices to equilibrium. If the forward points are mentioned simply as 5/8, then a doubt arises as to customer transaction expected to happen on 23 rdFebruary will be this margin loaded onto spot
whether it is at premium, and hence has to be added or at discount and hence to be deducted. The rate. Thus if the margin is 3 paise, the rate for an exporter will be 62.06 & for an importer, the rate
spot market always has the lowest bid- ask spread and the spread will steadily widen as the will be 62.12. This logic will be applied even while calculating exchange rate for a third currency
duration lengthens. though the calculation will be a bit lengthier.
 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT 79.9 9.10 STRATEGIC FINANCIAL MANAGEMENT

3.9 Merchant Rates arguments for and against giving freedom to banks for loading margins by banks themselves on
the ongoing interbank rate. However the liberalization wave overruled the skeptics.
It is always interesting to know who ‘fixes’ the exchange rates as quoted to customers and to
realize that nobody fixes but the market decides the exchange rate based on demand and supply The International Division of any bank calculates the merchant rates for variety of transactions like
and other relevant factors. RBI often clarifies that it does not fix the exchange rates, though in the import bill, export bill, inward & outward remittance etc. and advises the same in the morning with
same breath, RBI also clarifies that it monitors the ‘volatility’ of Indian rupee exchange rate. In standard spread loaded to all branches. It is called card rate. For a walk-in customer, for
other words, RBI does not control the exchange rates but it controls the volatile movement of INR transactions of small value [what is small varies with the bank], this is applied.
exchange rate by intervention i.e. by deliberately altering the demand and supply of the foreign However, for regular customers and for transactions of high value, always a better rate is sought
currency say USD. It does it by either buying USD from the interbank market or pumping in USD from the dealing room. Card rates advised in the margin are generally not changed unless there is
into the market. This wholesale interbank market rate is the basis for banks’ exchange rates too much volatility.
quoted to customers.
In foreign exchange market, banks consider customers as ‘merchants’ for historical reasons. It 4. EXCHANGE RATE FORECASTING
may look ridiculous to call an NRI who has remitted dollars to India as a merchant but exchange
rates applied to all types of customers including that for converting inward remittance in USD to The foreign exchange market has changed dramatically over the past few years. The amounts
INR are called merchant rates as against the rates quoted to each other by banks in the interbank traded each day in the foreign exchange market are now huge. In this increasingly challenging and
market, which are called interbank rates. Why this term is important here is because there are competitive market, investors and traders need tools to select and analyze the right data from the
guidelines issued by FEDAI [Foreign Exchange Dealers Association of India] to banks on these vast amounts of data available to them to help them make good decisions. Corporates need to do
merchant rates as there is customer service element involved in these. the exchange rate forecasting for taking decisions regarding hedging, short-term financing, short-
term investment, capital budgeting, earnings assessments and long-term financing.
Till 1998, FEDAI prescribed what ‘margins’ are to be loaded by banks onto the ongoing interbank
exchange rate for quoting to customers i.e. to arrive at the merchant rates. This was because, Techniques of Exchange Rate Forecasting: There are numerous methods available for
most customer affecting costs like interest rates were then controlled by regulators. forecasting exchange rates. They can be categorized into four general groups- technical,
fundamental, market-based, and mixed.
As a part of liberalization, banks got the freedom to quote their own rates. Since then, banks
decide themselves what should be the margin depending on the bank’s ‘position’. The only rule (a) Technical Forecasting: It involves the use of historical data to predict future values. For
that is still existing in the FEDAI rule book is rule 5A.8 which states that “Settlement of all example time series models. Speculators may find the models useful for predicting day-to-day
merchant transactions shall be effected on the principle of rounding off the Rupee amounts to the movements. However, since the models typically focus on the near future and rarely provide point
nearest whole Rupee i.e., without paise”. This means if an exporter or an individual has received or range estimates, they are of limited use to MNCs.
USD 1234 and if the applicable exchange rate is 61.32, then the amount to be credited to (b) Fundamental Forecasting: It is based on the fundamental relationships between economic
customer’s account is ` 75669 and not ` 75668.88, less charges if any. This rule will be similarly variables and exchange rates. For example subjective assessments, quantitative measurements
applicable for import or outward remittance transactions also. This rule is more a matter of based on regression models and sensitivity analyses.
common sense and does not have any meaningful impact on customer transactions. In fact in
In general, fundamental forecasting is limited by:
some of the banking software, amount is always rounded off.
 the uncertain timing of the impact of the factors,
After the discontinuation of gold standard in 1971 by USA, the foreign exchange market was in
turmoil. Initially, RBI had kept sterling as the intervention currency pegging the rupee exchange  the need to forecast factors that have an immediate impact on exchange rates,
rate for historical reasons and due to political legacy. Effective 1975, rupee was delinked from  the omission of factors that are not easily quantifiable, and
sterling and was linked to a basket of currencies. It should be noted that the concept of RBI/FEDAI
advising the fixed exchange rate was discontinued long ago. The sterling schedule was abolished  changes in the sensitivity of currency movements to each factor over time.
from the beginning of 1984. FEDAI issued detailed guidelines to banks on how to calculate (c) Market-Based Forecasting: It uses market indicators to develop forecasts. The current
exchange rates under the new freedom, the minimum & maximum profit margin and the maximum spot/forward rates are often used, since speculators will ensure that the current rates reflect the
spread between the buying and selling rates. All these are now redundant now. There were market expectation of the future exchange rate.
 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT 79.11 9.12 STRATEGIC FINANCIAL MANAGEMENT

(d) Mixed Forecasting: It refers to the use of a combination of forecasting techniques. The  One can buy 0.0217 US dollars for one Indian rupee.
actual forecast is a weighted average of the various forecasts developed.
 ` 46.08 Indian rupees are needed to buy one US dollar.
(b) The Forward Market: A forward exchange rate occurs when buyers and sellers of
5. EXCHANGE RATE DETERMINATION currencies agree to deliver the currency at some future date. They agree to transact a specific
An exchange rate is, simply, the price of one nation’s currency in terms of another currency, often amount of currency at a specific rate at a specified future date. The forward exchange rate is set
termed the reference currency. For example, the rupee/dollar exchange rate is just the number of and agreed by the parties and remains fixed for the contract period regardless of the fluctuations in
rupee that one dollar will buy. If a dollar will buy 100 rupee, the exchange rate would be expressed the spot exchange rates in future. The forward exchange transactions can be understood by an
as ` 100/$ and the rupee would be the reference currency. example.
Equivalently, the dollar/ rupee exchange rate is the number of dollars one rupee will buy. A US exporter of computer peripherals might sell computer peripherals to a German importer with
Continuing the previous example, the exchange rate would be $0.01/Rs (1/100) and the dollar immediate delivery but not require payment for 60 days. The German importer has an obligation to
would now be the reference currency. Exchange rates can be for spot or forward delivery. pay the required dollars in 60 days, so he may enter into a contract with a trader (typically a local
The foreign exchange market includes both the spot and forward exchange rates. The spot rate is banker) to deliver Euros for dollars in 60 days at a forward rate – the rate today for future delivery.
the rate paid for delivery within two business days after the day the transaction takes place. If the So, a forward exchange contract implies a forward delivery at specified future date of one currency
rate is quoted for delivery of foreign currency at some future date, it is called the forward rate. In for a specified amount of another currency. The exchange rate is agreed today, though the actual
the forward rate, the exchange rate is established at the time of the contract, though payment and transactions of buying and selling will take place on the specified date only. The forward rate is not
delivery are not required until maturity. Forward rates are usually quoted for fixed periods of 30, the same as the spot exchange rate that will prevail in future. The actual spot rate that may prevail
60, 90 or 180 days from the day of the contract. on the specified date is not known today and only the forward rate for that day is known. The
(a) The Spot Market: The most common way of stating a foreign exchange quotation is in actual spot rate on that day will depend upon the supply and demand forces on that day. The
terms of the number of units of foreign currency needed to buy one unit of home currency. Thus, actual spot rate on that day may be lower or higher than the forward rate agreed today.
India quotes its exchange rates in terms of the amount of rupees that can be exchanged for one An Indian exporter of goods to London could enter into a forward contract with his banker to sell
unit of foreign currency. pound sterling 90 days from now. This contract can also be described as a contract to purchase
Illustration 2 Indian Rupees in exchange for delivery of pound sterling. In other words, foreign exchange
markets are the only markets where barter happens – i.e., money is delivered in exchange for
If the Indian rupee is the home currency and the foreign currency is the US Dollar then what is the money!
exchange rate between the rupee and the US dollar?
Solution 6. EXCHANGE RATE THEORIES
US$ 0.0217/`1 reads "0.0217 US dollar per rupee." This means that for one Indian rupee one can There are three theories of exchange rate determination- Interest rate parity, Purchasing power
buy 0.0217 US dollar. parity and International Fisher effect.
In this method, known as the European terms, the rate is quoted in terms of the number of units of 6.1 Interest Rate Parity (IRP)
the foreign currency for one unit of the domestic currency. This is called an indirect quote.
Interest rate parity is a theory which states that ‘the size of the forward premium (or discount)
The alternative method, called the American terms, expresses the home currency price of one unit should be equal to the interest rate differential between the two countries of concern”. When
of the foreign currency. This is called a direct quote. interest rate parity exists, covered interest arbitrage (means foreign exchange risk is covered) is
This means the exchange rate between the US dollar and rupee can be expressed as: not feasible, because any interest rate advantage in the foreign country will be offset by the
discount on the forward rate. Thus, the act of covered interest arbitrage would generate a return
` 46.08/US$ reads "` 46.08 per US dollar."
that is no higher than what would be generated by a domestic investment.
Hence, a relationship between US dollar and rupee can be expressed in two different ways which
have the same meaning:
 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT 79.13 9.14 STRATEGIC FINANCIAL MANAGEMENT

The Covered Interest Rate Parity equation is given by: change in the prices of products should be somewhat similar when measured in a common
currency, as long as the transportation costs and trade barriers are unchanged.
F
(1 + rD ) = (1 + rF ) In Equilibrium Form:
S
Where, PD
S=α
(1 + rD) = Amount that an investor would get after a unit period by investing a rupee in the PF
F Where,
domestic market at rD rate of interest and (1 + rF ) is the amount that an investor by
S
S(`/$) = spot rate
investing in the foreign market at rF that the investment of one rupee yield same return in
the domestic as well as in the foreign market. PD = is the price level in India, the domestic market.
The Uncovered Interest Rate Parity equation is given by: PF = is the price level in the foreign market, the US in this case.
S1 α = Sectoral price and sectoral shares constant.
r + rD = (1 + rF )
S For example, A cricket bat sells for ` 1000 in India. The transportation cost of one bat from
Where, Ludhiana to New York costs ` 100 and the import duty levied by the US on cricket bats is
S1 = Expected future spot rate when the receipts denominated in foreign currency is converted into ` 200 per bat. Then the sectoral constant for adjustment would be 1000/1300 = 0.7692.
domestic currency. It becomes extremely messy if one were to deal with millions of products and millions of constants.
Thus, it can be said that Covered Interest Arbitrage has an advantage as there is an incentive to One way to overcome this is to use a weighted basket of goods in the two countries represented
invest in the higher-interest currency to the point where the discount of that currency in the forward by an index such as Consumer Price Index. However, even this could break down because the
market is less than the interest differentials. If the discount on the forward market of the currency basket of goods consumed in a country like Finland would vary with the consumption pattern in a
with the higher interest rate becomes larger than the interest differential, then it pays to invest in country such as Malaysia making the aggregation an extremely complicated exercise.
the lower-interest currency and take advantage of the excessive forward premium on this currency. The RELATIVE FORM of the Purchasing Power Parity tries to overcome the problems of market
imperfections and consumption patterns between different countries. A simple explanation of the
6.2 Purchasing Power Parity (PPP)
Relative Purchase Power Parity is given below:
Why is a dollar worth ` 48.80, JPY 122.18, etc. at some point in time? One possible answer is
Assume the current exchange rate between INR and USD is ` 50 / $1. The inflation rates are 12%
that these exchange rates reflect the relative purchasing powers of the currencies, i.e. the basket
in India and 4% in the US. Therefore, a basket of goods in India, let us say costing now
of goods that can be purchased with a dollar in the US will cost ` 48.80 in India and ¥ 122.18 in
` 50 will cost one year hence ` 50 x 1.12 = ` 56.00.A similar basket of goods in the US will cost
Japan.
USD 1.04 one year from now. If PPP holds, the exchange rate between USD and INR, one year
Purchasing Power Parity theory focuses on the ‘inflation – exchange rate’ relationship. There are hence, would be ` 56.00 = $1.04. This means, the exchange rate would be
two forms of PPP theory:- ` 53.8462 / $1, one year from now.This can also be worked backwards to say what should have
The ABSOLUTE FORM, also called the ‘Law of One Price’ suggests that “prices of similar been the exchange rate one year before, taking into account the inflation rates during last year and
products of two different countries should be equal when measured in a common currency”. If a the current spot rate.
discrepancy in prices as measured by a common currency exists, the demand should shift so that Expected spot rate = Current Spot Rate x expected difference in inflation rates
these prices should converge.
(1 + Id )
E(S1) = S0 x
An alternative version of the absolute form that accounts for the possibility of market imperfections (1 + 1f )
such as transportation costs, tariffs, and quotas embeds the sectoral constant. It suggests that
Where
‘because of these market imperfections, prices of similar products of different countries will not
necessarily be the same when measured in a common currency.’ However, it states that the rate of E(S1) is the expected Spot rate in time period 1
 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT 79.15 9.16 STRATEGIC FINANCIAL MANAGEMENT

S0 is the current spot rate (Direct Quote) adjust to offset interest rate differentials on the average. As we know that purchasing power has
not held over certain periods, and since the International Fisher Effect is based on Purchasing
Id is the inflation in the domestic country (home country)
Power Parity (PPP). It does not consistently hold either, because there are factors other than
If is the inflation in the foreign country inflation that affect exchange rates, the exchange rates do not adjust in accordance with the
According to Relative PPP, any differential exchange rate to the one propounded by the theory is inflation differential.
the ‘real appreciation’ or ‘real depreciation’ of one currency over the other. For example, if the 6.4 Comparison of PPP, IRP and IFE Theories
exchange rate between INR and USD one year ago was ` 45.00. If the rates of inflation in India
and USA during the last one year were 10% and 2% respectively, the spot exchange rate between All the above theories relate to the determination of exchange rates. Yet, they differ in their
the two currencies today should be implications.

S0 = 45.00 x (1+10%)/(1+2%) = ` 48.53 The theory of IRP focuses on why the forward rate differs from the spot rate and on the degree of
difference that should exist. This relates to a specific point in time.
However, if the actual exchange rate today is ` 50,00, then the real appreciation of the USD
against INR is ` 1.47, which is 1.47/45.00 = 3.27%. And this appreciation of the USD against INR Conversely, PPP theory and IFE theory focuses on how a currency’s spot rate will change over
is explained by factors other than inflation. time. While PPP theory suggests that the spot rate will change in accordance with inflation
differentials, IFE theory suggests that it will change in accordance with interest rate differentials.
PPP is more closely approximated in the long run than in the short run, and when disturbances are PPP is nevertheless related to IFE because inflation differentials influence the nominal interest
purely monetary in character. rate differentials between two countries.
6.3 International Fisher Effect (IFE) Theory Key Variables Basis Summary
International Fisher Effect theory uses interest rate rather than inflation rate differentials to explain Interest Rate Parity Forward rate Interest rate The forward rate of one
why exchange rates change over time, but it is closely related to the Purchasing Power Parity (IRP) premium (or differential currency will contain a
(PPP) theory because interest rates are often highly correlated with inflation rates. discount) premium (or discount) that is
determined by the differential
According to the International Fisher Effect, ‘nominal risk-free interest rates contain a real rate of in interest rates between the
return and anticipated inflation’. This means if investors of all countries require the same real two countries. As a result,
return, interest rate differentials between countries may be the result of differential in expected covered interest arbitrage will
inflation. provide a return that is no
higher than a domestic return.
The IFE theory suggests that foreign currencies with relatively high interest rates will depreciate
because the high nominal interest rates reflect expected inflation. The nominal interest rate would
also incorporate the default risk of an investment. Purchasing Power Percentage Inflation rate The spot rate of one currency
Parity (PPP) change in spot differential. w.r.t. another will change in
The IFE equation can be given by: exchange rate. reaction to the differential in
inflation rates between two
rD – PD = rF – ∆PF
countries. Consequently, the
or purchasing power for
consumers when purchasing
PD – PF = ∆S = rD –rF goods in their own country will
The above equation states that if there are no barriers to capital flows the investment will flow in be similar to their purchasing
such a manner that the real rate of return on investment will equalize. In fact, the equation power when importing goods
represents the interaction between real sector, monetary sector and foreign exchange market. from foreign country.
International Fisher Percentage Interest rate The spot rate of one currency
If the IFE holds, then a strategy of borrowing in one country and investing the funds in another Effect (IFE) change in spot differential w.r.t. another will change in
country should not provide a positive return on average. The reason is that exchange rates should
 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT 79.17 9.18 STRATEGIC FINANCIAL MANAGEMENT

exchange rate accordance with the Thus, a nation's commercial banks operate as clearing houses for the foreign exchange demanded
differential in interest rates and supplied in the course of foreign transactions by the nation's residents. Hence, four levels of
between the two countries. transactor or participants can be identified in foreign exchange markets. At the first level, are
Consequently, the return on tourists, importers, exporters, investors, etc. These are the immediate users and suppliers of
uncovered foreign money
foreign currencies. At the next or second level are the commercial banks which act as clearing
market securities will on
average be no higher than the houses between users and earners of foreign exchange. At the third level are foreign exchange
return on domestic money brokers through whom the nation's commercial banks even out their foreign exchange inflows and
market securities from the outflows among themselves. Finally, at the fourth and highest level is the nation's central bank
perspective of investors in the which acts as the lender or buyer of last resort when the nation's total foreign exchange earnings
home country. and expenditures are unequal. The central bank then either draws down its foreign exchange
reserves or adds to them.
7. FOREIGN EXCHANGE MARKET Market Participants

The foreign exchange market is the market in which individuals, firms and banks buy and sell The participants in the foreign exchange market can be categorized as follows:
foreign currencies or foreign exchange. The purpose of the foreign exchange market is to permit (i) Non-bank Entities: Many multinational companies exchange currencies to meet their
transfers of purchasing power denominated in one currency to another i.e. to trade one currency import or export commitments or hedge their transactions against fluctuations in exchange
for another. For example, a Japanese exporter sells automobiles to a US dealer for dollars, and a rate. Even at the individual level, there is an exchange of currency as per the needs of the
US manufacturer sells machine tools to Japanese company for yen. Ultimately, however, the US individual.
company will be interested in receiving dollars, whereas the Japanese exporter will want yen.
Because it would be inconvenient for the individual buyers and sellers of foreign exchange to seek (ii) Banks: Banks also exchange currencies as per the requirements of their clients.
out one another, a foreign exchange market has developed to act as an intermediary. (iii) Speculators: This category includes commercial and investment banks, multinational
Transfer of purchasing power is necessary because international trade and capital transactions companies and hedge funds that buy and sell currencies with a view to earn profit due to
usually involve parties living in countries with different national currencies. Each party wants to fluctuations in the exchange rates.
trade and deal in his own currency but since the trade can be invoiced only in a single currency, (iv) Arbitrageurs: This category includes those investors who make profit from price differential
the parties mutually agree on a currency beforehand. The currency agreed could also be any existing in two markets by simultaneously operating in two different markets.
convenient third country currency such as the US dollar. For, if an Indian exporter sells machinery
(v) Governments: The governments participate in the foreign exchange market through the
to a UK importer, the exporter could invoice in pound, rupees or any other convenient currency like
central banks. They constantly monitor the market and help in stabilizing the exchange
the US dollar.
rates.
But why do individuals, firms and banks want to exchange one national currency for another? The
demand for foreign currencies arises when tourists visit another country and need to exchange
8. FOREIGN EXCHANGE EXPOSURE
their national currency for the currency of the country they are visiting or when a domestic firm
wants to import from other nations or when an individual wants to invest abroad and so on. On the “An Exposure can be defined as a Contracted, Projected or Contingent Cash Flow whose
other hand, a nation's supply of foreign currencies arises from foreign tourist expenditures in the magnitude is not certain at the moment. The magnitude depends on the value of variables such as
nation, from export earnings, from receiving foreign investments, and so on. For example, suppose Foreign Exchange rates and Interest rates.”
a US firm exporting to the UK is paid in pounds sterling (the UK currency). The US exporter will In other words, exposure refers to those parts of a company’s business that would be affected if
exchange the pounds for dollars at a commercial bank. The commercial bank will then sell these exchange rate changes. Foreign exchange exposures arise from many different activities.
pounds for dollars to a US resident who is going to visit the UK or to a United States firm that
wants to import from the UK and pay in pounds, or to a US investor who wants to invest in the UK For example, travellers going to visit another country have the risk that if that country's currency
and needs the pounds to make the investment. appreciates against their own their trip will be more expensive.
 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT 79.19 9.20 STRATEGIC FINANCIAL MANAGEMENT

An exporter who sells his product in foreign currency has the risk that if the value of that foreign It measures the changes in the value of outstanding financial obligation incurred prior to a change
currency falls then the revenues in the exporter's home currency will be lower. in exchange rates but not due to be settled until after the exchange rates change.
An importer who buys goods priced in foreign currency has the risk that the foreign currency will Thus, it deals with the changes in the cashflow which arise from existing contractual obligation.
appreciate thereby making the local currency cost greater than expected.
In fact, the transaction exposures are the most common ones amongst all the exposures. Let’s
Fund Managers and companies who own foreign assets are exposed to fall in the currencies take an example of a company which exports to US, and the export receivables are also
where they own the assets. This is because if they were to sell those assets their exchange rate denominated in USD. While doing budgeting the company had assumed USDINR rate of 62 per
would have a negative effect on the home currency value. USD. By the time the exchange inward remittance arrives. USDINR could move down to 57
leading to wiping off of commercial profit for exporter. Such transaction exposures arise whenever
Other foreign exchange exposures are less obvious and relate to the exporting and importing in
a business has foreign currency denominated receipts or payments. The risk is an adverse
ones local currency but where exchange rate movements are affecting the negotiated price.
movement of the exchange rate from the time the transaction is budgeted till the time the exposure
8.1. Types of Exposures is extinguished by sale or purchase of the foreign currency against the domestic currency.
The foreign exchange exposure may be classified under three broad categories: 8.1.2 Translation Exposure
Also known as accounting exposure, it refers to gains or losses caused by the translation of
Moment in time when exchange rate changes foreign currency assets and liabilities into the currency of the parent company for consolidation
purposes.
Translation exposure, also called as accounting exposure, is the potential for accounting derived
Translation exposure Operating exposure changes in owner’s equity to occur because of the need to “translate” foreign currency financial
Accounting-based changes in
Change in expected cash flows arising statements of foreign subsidiaries into a single reporting currency to prepare worldwide
because of an unexpected change in
consolidated financial statements
exchange rates consolidated financial statements.
caused by a change in exchange
rates Translation exposures arise due to the need to “translate” foreign currency assets and liabilities
into the home currency for the purpose of finalizing the accounts for any given period. A typical
Transaction exposure example of translation exposure is the treatment of foreign currency loans.
Impact of setting outstanding obligations entered into before change in Consider that a company has taken a medium term loan to finance the import of capital goods
exchange rates but to be settled after the change in exchange rates
worth dollars 1 million. When the import materialized, the exchange rate was, say, USD/INRR-55.
The imported fixed asset was, therefore, capitalized in the books of the company at ` 550 lacs
Time
through the following accounting entry:
8.1.1 Transaction Exposure
Debit fixed assets ` 550 lacs
It measures the effect of an exchange rate change on outstanding obligations that existed before
Credit dollar loan ` 550 lacs
exchange rates changed but were settled after the exchange rate changes. Thus, it deals with
cash flows that result from existing contractual obligations. In the ordinary course, and assuming no change in the exchange rate, the company would have
provided depreciation on the asset valued at ` 550 lacs, for finalizing its account for the year in
Example: If an Indian exporter has a receivable of $100,000 due in six months hence and if the
which the asset was purchased.
dollar depreciates relative, to the rupee a cash loss occurs. Conversely, if the dollar appreciates
relative to the rupee, a cash gain occurs. However, what happens if at the time of finalization of the accounts the exchange rate has moved
to say USD/INR-58. Now the dollar loan will have to be “translated” at ` 58, involving a “translation
The above example illustrates that whenever a firm has foreign currency denominated receivables
loss” of a ` 30 lacs. It shall have to be capitalized by increasing the book value of the asset, thus
or payables, it is subject to transaction exposure and their settlements will affect the firm’s cash
making the figure ` 380 lacs and consequently higher depreciation will have to be provided, thus
flow position.
reducing the net profit.
 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT 79.21 9.22 STRATEGIC FINANCIAL MANAGEMENT

It will be readily seen that both transaction and translation exposures affect the bottom line of a (i) Invoicing in Domestic Currency: Companies engaged in exporting and importing,
company. The effect could be positive as well if the movement is favourable – i.e., in the cited whether of goods or services, are concerned with decisions relating to the currency in which goods
examples, in case the USD would have appreciated in case of Transaction Exposure example, or and services are invoked. Trading in a foreign currency gives rise to transaction exposure.
the USD would have depreciated in case of Translation Exposure, for example, against the rupee. Although trading purely in a company's home currency has the advantage of simplicity, it fails to
take account of the fact that the currency in which goods are invoiced has become an essential
An important observation is that the translation exposure, of course, becomes a transaction
aspect of the overall marketing package given to the customer. Sellers will usually wish to sell in
exposure at some stage: the dollar loan has to be repaid by undertaking the transaction of
their own currency or the currency in which they incur cost. This avoids foreign exchange
purchasing dollars.
exposure. But buyers' preferences may be for other currencies. Many markets, such as oil or
8.1.3 Economic Exposure aluminum, in effect require that sales be made in the same currency as that quoted by major
It refers to the extent to which the economic value of a company can decline due to changes in competitors, which may not be the seller's own currency. In a buyer's market, sellers tend
exchange rate. It is the overall impact of exchange rate changes on the value of the firm. The increasingly to invoice in the buyer's ideal currency. The closer the seller can approximate the
essence of economic exposure is that exchange rate changes significantly alter the cost of a firm’s buyer's aims, the greater chance he or she has to make the sale.
inputs and the prices of its outputs and thereby influence its competitive position substantially. Should the seller elect to invoice in foreign currency, perhaps because the prospective customer
Effects of Local Currency Fluctuations on Company’s Economic Exposure (Cash inflow) prefers it that way or because sellers tend to follow market leader, then the seller should choose
only a major currency in which there is an active forward market for maturities at least as long as
Variables influencing the inflow Revaluation Devaluation the payment period. Currencies, which are of limited convertibility, chronically weak, or with only a
of cash in Local currency impact impact limited forward market, should not be considered.
Local sale, relative to foreign Decrease Increase The seller’s ideal currency is either his own, or one which is stable relative to it. But often the seller
Competition in local currency is forced to choose the market leader’s currency. Whatever the chosen currency, it should certainly
Company’s export in local currency Decrease Increase be one with a deep forward market. For the buyer, the ideal currency is usually its own or one that
Company’s export in foreign currency Decrease Increase is stable relative to it, or it may be a currency of which the purchaser has reserves.
Interest payments from foreign investments Decrease Increase (ii) Leading and Lagging: Leading and Lagging refer to adjustments in the times of payments
Effects of Local Currency Fluctuations on Company’s Economic Exposure (Cash outflow) in foreign currencies. Leading is the payment before due date while lagging is delaying payment
past the due date. These techniques are aimed at taking advantage of expected devaluation
Variables influencing the Revaluation Devaluation
and/or revaluation of relevant currencies. Lead and lag payments are of special importance in the
outflow of cash in local currency impact impact event that forward contracts remain inconclusive. For example, Subsidiary b in B country owes
Company’s import of material Remain the same Remain the same money to subsidiary a in country A with payment due in three months’ time, and with the debt
the same denoted in local currency denominated in US dollar. On the other side, country B’s currency is expected to devalue within
Company’s import of material Decrease Increase three months against US dollar, vis-à-vis country A’s currency. Under these circumstances, if
denoted in foreign currency company b leads -pays early - it will have to part with less of country B’s currency to buy US
Interest on foreign debt Decrease Increase dollars to make payment to company A. Therefore, lead is attractive for the company. When we
take reverse the example-revaluation expectation- it could be attractive for lagging.

9. HEDGING CURRENCY RISK (iii) Netting: Netting involves associated companies, which trade with each other. The
technique is simple. Group companies merely settle inter affiliate indebtedness for the net amount
There are a range of hedging instruments that can be used to reduce risk. Broadly these owing. Gross intra-group trade, receivables and payables are netted out. The simplest scheme is
techniques can be divided into known as bilateral netting and involves pairs of companies. Each pair of associates nets out their
(A) Internal Techniques: These techniques explicitly do not involve transaction costs and can be own individual positions with each other and cash flows are reduced by the lower of each
used to completely or partially offset the exposure. These techniques can be further classified as company's purchases from or sales to its netting partner. Bilateral netting involves no attempt to
follows: bring in the net positions of other group companies.
 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT 79.23 9.24 STRATEGIC FINANCIAL MANAGEMENT

Netting basically reduces the number of inter company payments and receipts which pass over the economic sense but emphasis on pure translation exposure is misplaced. Hence our focus here is
foreign exchanges. Fairly straightforward to operate, the main practical problem in bilateral netting on asset liability management as a cash flow exposure management technique.
is usually the decision about which currency to use for settlement.
In essence, asset and liability management can involve aggressive or defensive postures. In the
Netting reduces banking costs and increases central control of inter company settlements. The aggressive attitude, the firm simply increases exposed cash inflows denominated in currencies
reduced number and amount of payments yield savings in terms of buy/sell spreads in the spot expected to be strong or increases exposed cash outflows denominated in weak currencies. By
and forward markets and reduced bank charges. contrast, the defensive approach involves matching cash inflows and outflows according to their
currency of denomination, irrespective of whether they are in strong or weak currencies.
(iv) Matching: Although netting and matching are terms, which are frequently used
interchangeably, there are distinctions. Netting is a term applied to potential flows within a group of (B) External Techniques: Under this category range of various financial products are used which
companies whereas matching can be applied to both intra-group and to third-party balancing. can be categorized as follows:
Matching is a mechanism whereby a company matches its foreign currency inflows with its foreign (i) Money Market Hedging: At its simplest, a money market hedge is an agreement to
currency outflows in respect of amount and approximate timing. Receipts in a particular currency exchange a certain amount of one currency for a fixed amount of another currency, at a particular
are used to make payments in that currency thereby reducing the need for a group of companies date. For example, suppose a business owner in India expects to receive 1 Million USD in six
to go through the foreign exchange markets to the unmatched portion of foreign currency cash months. This Owner could create an agreement now (today) to exchange 1Million USD for INR at
flows. roughly the current exchange rate. Thus, if the USD dropped in value by the time the business
owner got the payment, he would still be able to exchange the payment for the original quantity of
The prerequisite for a matching operation is a two-way cash flow in the same foreign currency
U.S. dollars specified.
within a group of companies; this gives rise to a potential for natural matching. This should be
distinguished from parallel matching, in which the matching is achieved with receipt and payment Advantages and Disadvantages of Money Market Hedge: Following are the advantages and
in different currencies but these currencies are expected to move closely together, near enough in disadvantages of this technique of hedging.
parallel.
Advantages
Both Netting and Matching presuppose that there are enabling Exchange Control regulations. For
(a) Fixes the future rate, thus eliminating downside risk exposure
example, an MNC subsidiary in India cannot net its receivable(s) and payable(s) from/to its
associated entities. Receivables have to be received separately and payables have to be paid (b) Flexibility with regard to the amount to be covered
separately. (c) Money market hedges may be feasible as a way of hedging for currencies where forward
(v) Price Variation: Price variation involves increasing selling prices to counter the adverse contracts are not available.
effects of exchange rate change. This tactic raises the question as to why the company has not Disadvantages include:
already raised prices if it is able to do so. In some countries, price increases are the only legally
available tactic of exposure management. (a) More complicated to organise than a forward contract

Let us now concentrate to price variation on inter company trade. Transfer pricing is the term used (b) Fixes the future rate - no opportunity to benefit from favourable movements in exchange
to refer to the pricing of goods and services, which change hands within a group of companies. As rates.
an exposure management technique, transfer price variation refers to the arbitrary pricing of inter (ii) Derivative Instruments: A derivatives transaction is a bilateral contract or payment
company sales of goods and services at a higher or lower price than the fair price, arm’s length exchange agreement whose value depends on - derives from - the value of an underlying asset,
price. This fair price will be the market price if there is an existing market or, if there is not, the reference rate or index. Today, derivatives transactions cover a broad range of underlying -
price which would be charged to a third party customer. Taxation authorities, customs and excise interest rates, exchange rates, commodities, equities and other indices.
departments and exchange control regulations in most countries require that the arm’s length
In addition to privately negotiated, global transactions, derivatives also include standardized
pricing be used.
futures and options on futures that are actively traded on organized exchanges and securities such
(vi) Asset and Liability Management: This technique can be used to manage balance as call warrants.
sheet, income statement or cash flow exposures. Concentration on cash flow exposure makes
 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT 79.25 9.26 STRATEGIC FINANCIAL MANAGEMENT

The term derivative is also used to refer to a wide variety of other instruments. These have payoff To calculate the Premium or Discount of a currency vis-à-vis another, we need to find out how
characteristics, which reflect the fact that they include derivatives products as part of their make- much each unit of the first currency can buy units of the second currency. For instance, if the Spot
up. rate between INR and USD is ` 55 to a dollar and the six months forward rate is ` 60 to a dollar, it
is clear the USD is strengthening against the Rupee and hence is at a premium. Which also means
Transaction risk can also be hedged using a range of financial derivatives products which include:
that Rupee is at discount.
Forwards, futures, options, swaps, etc. These instruments are discussed in detailed manner in
following pages. The premium of USD against INR is ` 5 for six months in absolute terms. However, forward
premium is always expressed as an annual percentage. Therefore, this premium is calculated as
10. FORWARD CONTRACT [ (Forward Rate – Spot rate) / (Spot rate) ] x (12/6)
The simplest form of derivatives is the forward contract. It obliges one party to buy, and the other = (60 – 55 )/(55) x 12/6 = 18.18%
to sell, a specified quantity of a nominated underlying financial instrument at a specific price, on a
Rupee is at discount and to calculate the discount, we need to find out how many dollars each
specified date in the future. There are markets for a multitude of underlying. Among these are the
Rupee can buy today and six months from now. Therefore, the Spot rate of USD in terms of INR
traditional agricultural or physical commodities, currencies (foreign exchange forwards) and
today is USD 1/55 = $ 0.01818 and six months from now is USD 1/60 = $ 0.01667. The discount is
interest rates (forward rate agreements - FRAs). The volume of trade in forward contracts is
calculated as:
massive.
[ (Forward Rate – Spot rate) / (Spot rate) ] x (12/6)
10.1 Forward Rate – Premium and Discount
= (0.01667 – 0.01818) / 0.01818 x 12/6
The change in value in a forward contract is broadly equal to the change in value in the underlying.
Forwards differ from options in that options carry a different payoff profile. Forward contracts are = – 0.00151 / 0.01818 x 12/6 = – 16.61%
unique to every trade. They are customized to meet the specific requirements of each end-user. The minus sign implies that the Rupee is at discount.
The characteristics of each transaction include the particular business, financial or risk-
Another important point to be noted in the above example, is that the forward premiums do not
management targets of the counterparties. Forwards are not standardized. The terms in relation to
contract size, delivery grade, location, delivery date and credit period are always negotiated. equal forward discount always. In the aforesaid example, for instance, the rupee is trading at a
discount of 16.67% while the dollar is trading at a premium of 18.18%.
In a forward contract, the buyer of the contract draws its value at maturity from its delivery terms or
a cash settlement. On maturity, if the price of the underlying is higher than the contract price the 10.2 Fate of Forward Contracts
buyer makes a profit. If the price is lower, the buyer suffers a loss. The gain to the buyer is a loss Whenever any forward contract is entered, normally it meets any of the following three fates.
to the seller.
(A) Delivery under the Contract
 Forwards Rates: The forward rate is different from the spot rate. Depending upon whether the
forward rate is greater than the spot rate, given the currency in consideration, the forward may (B) Cancellation of the Contract
either be at a 'discount' or at a 'premium'. Forward premiums and discounts are usually (C) Extension of the Contract
expressed as an annual percentages of the difference between the spot and the forward rates.
Further above of fates of forward contract can further classified into following sub-categories.
 Premium: When a currency is costlier in forward or say, for a future value date, it is said to
(A) Delivery under the Contract
be at a premium. In the case of direct method of quotation, the premium is added to both
the selling and buying rates. (i) Delivery on Due Date
 Discount: If the currency is cheaper in forward or for a future value date, it is said to be at a (ii) Early Delivery
discount. In case of direct quotation the discount is deducted from both the selling and (iii) Late Delivery
buying rate. The following example explains how to calculate Premium / Discount both
under Indirect/Direct quotes.
 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT 79.27 9.28 STRATEGIC FINANCIAL MANAGEMENT

(B) Cancellation of the Contract Illustration 4

(i) Cancellation on Due Date On 1 October 2015 Mr. X an exporter enters into a forward contract with a BNP Bank to sell US$
1,00,000 on 31 December 2015 at ` 65.40/$. However, due to the request of the importer, Mr. X
(ii) Early Cancellation
received amount on 28 November 2015. Mr. X requested the bank the take delivery of the
(iii) Late Cancellation remittance on 30 November 2015 i.e. before due date. The inter-banking rates on 28 November
(C) Extension of the Contract 2015 was as follows:

(i) Extension on Due Date Spot ` 65.22/65.27

(ii) Early Extension One Month Premium 10/15

(iii) Late Extension If bank agrees to take early delivery then what will be net inflow to Mr. X assuming that the
prevailing prime lending rate is 18%.
Let us discuss each of above executions one by one.
Solution
Delivery on Due Date
Bank will buy from customer at the agreed rate of ` 65.40. In addition to the same if bank will
This situation does not pose any problem as rate applied for the transaction would be rate charge/ pay swap difference and interest on outlay funds.
originally agreed upon. Exchange shall take place at this rate irrespective of the spot rate
prevailing. (a) Swap Difference
Bank Sells at Spot Rate on 28 November 2015 ` 65.22
Illustration 3
Bank Buys at Forward Rate of 31 December 2015 (65.27 + 0.15) ` 65.42
On 1st June 2015 the bank enters into a forward contract for 2 months for selling US$ 1,00,000 Swap Loss per US$ ` 00.20
at` 65.5000. On 1st July 2015 the spot rate was ` 65.7500/65.2500. Calculate the amount to be
Swap loss for US$ 1,00,000 ` 20,000
debited in the customer’s account.
(b) Interest on Outlay Funds
Answer On 28th November Bank sells at ` 65.22
The bank will apply rate originally agreed upon i.e. ` 65.5000 and will debit the account of the It buys from customer at ` 65.40
customer with ` 65,50,000. Outlay of Funds per US$ ` 00.18
Early Delivery Interest on Outlay fund for US$ 1,00,000 for 31 days ` 275.00
(US$100000 x 00.18 x 31/365 x 18%)
The bank may accept the request of customer of delivery at the before due date of forward
contract provided the customer is ready to bear the loss if any that may accrue to the bank as a (c) Charges for early delivery
result of this. In addition to some prescribed fixed charges bank may also charge additional Swap loss ` 20,000.00
charges comprising of: Interest on Outlay fund for US$ 1,00,000 for 31 days ` 275.00
(a) Swap Difference: This difference can be loss/ gain to the bank. This arises on account of ` 20,275.00
offsetting its position earlier created by early delivery as bank normally covers itself against (d) Net Inflow to Mr. X
the position taken in the original forward contract. Amount received on sale (` 65.40 x 1,00,000) ` 65,40,000
(b) Interest on Outlay of Funds: It might be possible early delivery request of a customer may Less: Charges for early delivery payable to bank (` 20,275)
result in outlay of funds. In such bank shall charge from the customer at a rate not less than ` 65,19,725
prime lending rate for the period of early delivery to the original due date. However, if there
is an inflow of funds the bank at its discretion may pass on interest to the customer at the
rate applicable to term deposits for the same period.
 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT 79.29 9.30 STRATEGIC FINANCIAL MANAGEMENT

Late Delivery Early Cancellation

In case of late delivery current rate prevailing on such date of delivery shall be applied. However, If a forward is required to be cancelled earlier than the due date of forward contract same shall be
before this delivery (execution) takes place the provisions of Automatic Cancellation (discussed cancelled at opposite rate of original contract of the date that synchronises with the date of original
later on) shall be applied. forward contract.
Cancellation on Due Date Illustration 6
In case of cancellation on due date in addition of flat charges (if any) the difference between You as a banker has entered into a 3 month’s forward contract with your customer to purchase
contracted rate and the cancellation rate (reverse action of original contract) is charged from/ paid AUD 1,00,000 at the rate of ` 47.2500. However after 2 months your customer comes to you and
to the customer. requests cancellation of the contract. On this date quotation for AUD in the market is as follows:
Illustration 5 Spot ` 47.3000/3500 per AUD
On 15th January 2015 you as a banker booked a forward contract for US$ 250000 for your import 1 month forward ` 47.4500/5200 per AUD
customer deliverable on 15th March 2015 at ` 65.3450. On due date customer request you to
Determine the cancellation charges payable by the customer.
cancel the contract. On this date quotation for US$ in the inter-bank market is as follows:
Solution
Spot ` 65.2900/2975 per US$
The contract shall be cancelled at the 1 month forward sale rate of ` 47.5200 as follows:
Spot/ April 3000/ 3100
AUD bought from customer under original forward contract at ` 47.2500
Spot/ May 6000/ 6100
On cancellation it is sold to him at ` 47.5200
Assuming that the flat charges for the cancellation is ` 100 and exchange margin is 0.10%, then
determine the cancellation charges payable by the customer. Net amount payable by customer per AUD ` 00.2700
Solution Thus total cancellation charges payable by the customer ` 27,000
Bank will buy from customer at the agreed rate of ` 65.40. Late Cancellation
Since this is sale contract the contract shall be cancelled at ready buying rate on the date of In case of late cancellation of Forward Contract the provisions of Automatic Cancellation
cancellation as follows: (discussed later on) shall be applied.
Spot Buying Rate on 15 March 2015 ` 65.2900 Extension on Due Date
Less: Exchange Margin ` 0.0653 It might also be possible that an exporter may not be able to export goods on the due date.
` 65.2247 Similarly it might also be possible that an importer may not to pay on due date. In both of these
Rounded to ` 65.2250 situations an extension of contract for selling and buying contract is warranted. Accordingly, if
Dollar sold to customer at ` 65.3450 earlier contract is extended first it shall be cancelled and rebooked for the new delivery period. In
Dollar bought from customer ` 65.2250 case extension is on due date it shall be cancelled at spot rate as like cancellation on due date
Net amount payable by the customer per US$ ` 0.1200 (discussed earlier) and new contract shall be rebooked at the forward rate for the new delivery
period.
Amount payable by the customer
Flat Charges ` 100.00 Illustration 7
Cancellation Charges (` 0.12 x 250000) `30,000.00 Suppose you are a banker and one of your export customer has booked a US$ 1,00,000 forward
`30,100.00 sale contract for 2 months with you at the rate of ` 62.5200 and simultaneously you covered
yourself in the interbank market at ` 62.5900. However on due date, after 2 months your customer
 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT 79.31 9.32 STRATEGIC FINANCIAL MANAGEMENT

comes to you and requests for cancellation of the contract and also requests for extension of the Spot/ 5th June ` 59.2300/2425 per US$
contract by one month. On this date quotation for US$ in the market was as follows:
Spot/ 5thJuly ` 59.6300/6425 per US$
Spot ` 62.7200/62.6800
Assuming a margin 0.10% on buying and selling, determine the extension charges payable by the
1 month forward ` 62.6400/62.7400 customer and the new rate quoted to the customer.
Determine the extension charges payable by the customer assuming exchange margin of 0.10% Solution
on buying as well as selling.
(a) Cancellation of Original Contract
Solution
The forward purchase contract shall be cancelled at the for the forward sale rate for delivery
Cancellation June.
First the original contract shall be cancelled as follows: Interbank forward selling rate ` 59.2425
US$/` Spot Selling Rate ` 62.7200 Add: Exchange Margin ` 0.0592
Add: Margin @ 0.10% ` 0.06272
Net amount payable by customer per US$ ` 59.3017
Net amount payable by customer per US$ ` 62.78272
Rounded off, the rate applicable is ` 59.3000
Rounded off ` 62.7825
Bank buys US$ under original contract at ` 62.5200 Buying US$ under original contract at original rate ` 59.6000
Bank Sells at ` 62.7825 Selling rate to cancel the contract ` 59.3000
` 0.2675 Difference per US$ ` 00.3000
Thus total cancellation charges payable by the customer for US$ 1,00,000 is ` 26,750. Exchange difference for US$ 50,000 payable to the customer is ` 15,000.
Rebooking
(b) Rate for booking new contract
Forward US$/` Buying Rate ` 62.6400
The forward contract shall be rebooked with the delivery 15 th July as follows:
Less: Margin @ 0.10% ` 0.06264
Net amount payable by customer per US$ ` 62.57736 Forward buying rate (5th July) ` 59.6300
Rounded off ` 62.5775 Less: Exchange Margin ` 0.0596
Extension before Due Date Net amount payable by customer per US$ ` 59.5704
In case any request to extend the contract is received before due date of maturity of forward Rounded off to ` 59.5700
contract, first the original contract would be cancelled at the relevant forward rate as in case of Late Extension
cancellation of contract before due date and shall be rebooked at the current forward rate of the
forward period. In case of late extension current rate prevailing on such date of delivery shall be applied. However,
before this delivery the provisions of Automatic Cancellation (discussed later on) shall be applied.
Illustration 8
Suppose you as a banker entered into a forward purchase contract for US$ 50,000 on 5 th March Automatic Cancellation
with an export customer for 3 months at the rate of ` 59.6000. On the same day you also covered As per FEDAI Rule 8 a forward contract which remains overdue without any instructions from the
yourself in the market at ` 60.6025. However on 5th May your customer comes to you and requests customers on or before due date shall stand automatically cancelled on 15 th day from the date of
extension of the contract to 5thJuly. On this date (5th May) quotation for US$ in the market is as maturity. Though customer is liable to pay the exchange difference arising there from but not
follows: entitled for the profit resulting from this cancellation.
Spot ` 59.1300/1400 per US$
 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT 79.33 9.34 STRATEGIC FINANCIAL MANAGEMENT

For late delivery and extension after due date as mentioned above the contract shall be treated as Exchange Margin 0.10% and interest on outlay of funds @ 12%. The importer requested on 20th
fresh contract and appropriate rates prevailing on such date shall be applicable as mentioned June for extension of contract with due date on 10th August.
below:
Rates rounded to 4 decimal in multiples of 0.0025.
1. Late Delivery: In this case the relevant spot rate prevailing on the such date shall be
On 10th June, Bank Swaps by selling spot and buying one month forward.
applicable.
Calculate:
2. Extension after Due Date: In this case relevant forward rate for the period desired shall be
applicable. (i) Cancellation rate

As mentioned earlier in both of above case cancellation charges shall be payable consisting of (ii) Amount payable on $ 2,00,000
following: (iii) Swap loss
(i) Exchange Difference: The difference between Spot Rate of offsetting position (cancellation (iv) Interest on outlay of funds, if any
rate) on the date of cancellation of contract after due date or 15 days (whichever is earlier)
and original rate contracted for. (v) New contract rate

(ii) Swap Loss: The loss arises on account of offsetting its position created by early delivery as (vi) Total Cost
bank normally covers itself against the position taken in the original forward contract. This Solution
position is taken at the spot rate on the date of cancellation earliest forward rate of
(i) Cancellation Rate:
offsetting position.
The forward sale contract shall be cancelled at Spot TT Purchase for $ prevailing on the
(iii) Interest on Outlay of Funds: Interest on the difference between the rate entered by the bank
date of cancellation as follows:
in the interbank market and actual spot rate on the due date of contract of the opposite
position multiplied by the amount of foreign currency amount involved. This interest shall be $/ ` Market Buying Rate ` 63.6800
calculated for the period from the due date of maturity of the contract and the actual date of Less: Exchange Margin @ 0.10% ` 0.0636
cancellation of the contract or 15 days whichever is later.
` 63.6163
Please note in above in any case there is profit by the bank on any course of action same shall not
be passed on the customer as normally passed cancellation and extension on or before due dates. Rounded off to ` 63.6175

Illustration 9 (ii) Amount payable on $ 2,00,000

An importer booked a forward contract with his bank on 10th April for USD 2,00,000 due on 10th Bank sells $2,00,000 @ ` 64.4000 ` 1,28,80,000
June @ ` 64.4000. The bank covered its position in the market at ` 64.2800. Bank buys $2,00,000 @ ` 63.6163 ` 1,27,23,260
The exchange rates for dollar in the interbank market on 10th June and 20th June were: Amount payable by customer ` 1,56,740

10th June 20th June (iii) Swap Loss

Spot USD 1= ` 63.8000/8200 ` 63.6800/7200 On 10th June the bank does a swap sale of $ at market buying rate of ` 63.8000 and
Spot/June ` 63.9200/9500 ` 63.8000/8500 forward purchase for June at market selling rate of ` 63.9500.
July ` 64.0500/0900 ` 63.9300/9900 Bank buys at ` 63.9500
August ` 64.3000/3500 ` 64.1800/2500 Bank sells at ` 63.8000
September ` 64.6000/6600 ` 64.4800/5600
Amount payable by customer ` 0.1500

Swap Loss for $ 2,00,000 in ` = ` 30,000

 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT 79.35 9.36 STRATEGIC FINANCIAL MANAGEMENT

(iv) Interest on Outlay of Funds 10.4 Rollover of Deliverable Forward Contract

On 10thApril, the bank receives delivery under cover contract at ` 64.2800 and sell spot at ` Rollover of Deliverable Forward Contract is a Contract wherein, as an Exporter, you have no
63.8000. Foreign Currency to Deliver at maturity and as an Importer you have no Local Currency to deliver
Bank buys at at maturity. As an Exporter or Importer you would like to rollover the contract which effectively
` 64.2800
means spot cancellation and booking of new contract for later date.
Bank sells at ` 63.8000
The rationale behind the rollover is:
Amount payable by customer ` 0.4800
 Non receipt of Foreign Currency from client (export perspective),
Outlay for $ 2,00,000 in ` 96,000
 Shortage of local currencies (Import perspective) ,
Interest on ` 96,000 @ 12% for 10 days ` 320
 Non-agreement of payment with clients,
(v) New Contract Rate
 Non availability of longer period forward contracts as normally forward contracts are
The contract will be extended at current rate available maximum for one year and to hedge the exposure for the period more than one
$/ ` Market forward selling Rate for August ` 64.2500 roll over contract shall be used.
Add: Exchange Margin @ 0.10% ` 0.0643
` 64.3143 11. FUTURES CONTRACTS
A basic futures contract is very similar to the forward contract in its obligation and payoff profile.
Rounded off to ` 64.3150
There are some important distinctions between futures and forwards and swaps.
(vi) Total Cost
 The contract terms of futures are standardized. These encompass:
Cancellation Charges ` 1,56,740.00
Swap Loss ` 30,000.00 • Quantity and quality of the underlying;
Interest ` 320.00 • Time and place of delivery;
` 1,87,060.00 • Method of payment.

10.3 Non-deliverable Forward Contract  Credit risk is standardized as this is greatly reduced by marking the contract to market on a
daily basis with daily checking of position.
A cash-settled, short-term forward contract on a thinly traded or non-convertible foreign currency,
where the profit or loss at the time at the settlement date is calculated by taking the difference  Futures are smaller in contract size than forwards and swaps, which means that they are
between the agreed upon exchange rate and the sport rate at the time of settlement, for an agreed available to a wider business market.
upon notional amount of funds. A financial futures contract is purchased or sold through a broker. It is a commitment to make or
All NDFs have a fixing date and a settlement date. The fixing date is the date at which the take delivery of a specified financial instrument, or perform a particular service, at predetermined
difference between the prevailing market exchange rate and the agreed upon exchange rate is date in the future. The price of the contract is established at the outset.
calculated. The settlement date is the date by which the payment of the difference is due to the Distinction between Futures and Forward Contracts
party receiving payment.
There are major differences between the traditional forward contract and a futures contract. These
NDFs are commonly quoted for time periods of one month up to one year, and are normally quoted are tabulated below:
and settled in U.S. dollars. They have become a popular instrument for corporations seeking to
hedge exposure to foreign currencies that are not internationally traded. Feature Forward Contract Futures Contract
Amount Flexible Standard amount
 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT 79.37 9.38 STRATEGIC FINANCIAL MANAGEMENT

Maturity Any valid business date Standard date. Usually one Call Option: It is a contract that gives the buyer the right, but not the obligation, to buy a specified
agreed to by the two delivery date such as the second number of units of commodity or a foreign currency from the seller of option at a fixed price on or
parties Tuesday of every month up to a specific date.
Furthest maturity Open 12 months forward Put Option: It is a contract that gives the buyer the right, but not the obligation, to sell a specified
date number of units of commodity or a foreign currency to a seller of option at a fixed price on or up to
Currencies traded All currencies Majors a specific date.
Cross rates Available in one contract; Usually requires two contracts Distinction between Options and Futures
Multiple contracts avoided
There are certain fundamental differences between a futures and an option contract. Let us look
Market-place Global network Regular markets − futures market
at the main comparative features given below:
and exchanges
Price fluctuations No daily limit in many Daily price limit set by exchange Options Futures
currencies (a) Only the seller (writer) is obliged to Both the parties are obligated to
Risk Depends on counter party Minimal due to margin perform perform.
requirements (b) Premium is paid by the buyer to the seller No premium is paid by any party.
Honouring of By taking and giving Mostly by a reverse transaction at the inception of the contract
contract delivery (c) Loss is restricted while there is unlimited There is potential/risk for unlimited
Cash flow None until maturity date Initial margin plus ongoing gain potential for the option buyer. gain/loss for the futures buyer.
variation margin because of (d) An American option contract can be A futures contract has to be honoured
market to market rate and final exercised any time during its period by by both the parties only on the date
payment on maturity date the buyer. specified.
Trading hours 24 hours a day 4 − 8 hours trading sessions
Options Vs Futures: Gain and Losses in Different Circumstances
Price Type of Position Held
12. OPTION CONTRACTS
Movement
An option is a contract which has one or other of two key attributes: Call buyer Long Call Seller Put Buyer Short Put Seller
• to buy (call option); Futures Futures
Position Position
• or to sell (put option).
Price rises Unlimited Unlimited Unlimited Limited Unlimited Limited
The purchaser is called the buyer or holder; the seller is called the writer or grantor. The premium gain gain loss loss loss gain
may be expressed as a percentage of the price per unit of the underlying. Price falls Limited Unlimited Limited Unlimited Unlimited Unlimited
The holder of an American option has the right to exercise the contract at any stage during the loss loss* gain gain* gain* loss*
period of the option, whereas the holder of a European option can exercise his right only at the Price Limited No gain or Limited Limited No Gain or Limited
end of the period. unchanged loss loss gain loss loss gain
During or at the end of the contract period (depending on the type of the option)the holder can do Note: Transaction Costs are ignored.
as he pleases. He can buy or sell (as the case may be) the underlying, let the contract expire or
*Since the price of any commodity; share are financial instrument cannot go below zero, there is
sell the option contract itself in the market.
technically a ‘limit’ to the gain/loss when the price falls. For practical purposes, this is largely
irrelevant.
 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT 79.39 9.40 STRATEGIC FINANCIAL MANAGEMENT

A currency swap has the following benefits:

13. SWAP CONTRACTS
 Treasurers can hedge currency risk.
Swaps are infinitely flexible. In technical terms they are a method of exchanging the underlying
economic basis of a debt or asset without affecting the underlying principal obligation on the debt  It can provide considerable cost savings. A strong borrower in the Japanese Yen market
or asset. may be interested in borrowing in the American USD markets where his credit rating may
not be as good as it is in Tokyo. Such a borrower could get a better US dollar rate by
A swap transaction commits the participants to exchange cash flows at specified intervals, which raising funds first in the Tokyo market and then swapping Yen for US dollars.
are called payment or settlement dates. Cash flows are either fixed or calculated for specific dates
by multiplying the quantity of the underlying by specified reference rates or prices.  The swap market permits funds to be accessed in currencies, which may otherwise
command a high premium.
The vast majority of swaps are classified into the following groups:
 It offers diversification of borrowings.
 Interest rate;
A more complex version of a currency swap is a currency coupon swap, which swaps a fixed-or-
 Currency; floating rate interest payment in one currency fora floating rate payment in another. These are also
 Commodity; known as Circus Swaps.

 Equity. In a currency swap the principal sum is usually exchanged:

The notional principal (i.e. the face value of a security) on all these, except currency swaps, is  At the start;
used to calculate the payment stream but not exchanged. Interim payments are usually netted -  At the end;
the difference is paid by one party to the other.
 At a combination of both; or
Like forwards, the main users of swaps are large multinational banks or corporations. Swaps
create credit exposures and are individually designed to meet the risk-management objectives of  Neither.
the participants. Many swaps are linked to the issue of a Eurobond. An issuer offers a bond in a currency and
instrument where it has the greatest competitive advantage. It then asks the underwriter of the
13.1 Interest Rate Swaps
bond to provide it with a swap to convert funds into the required type.
Interest Rate Swap has been covered in greater details in the Chapter 12 of this Study Material.
Please refer the same from there. 13.3 Equity Swaps
An equity swap is an arrangement in which total return on equity or equity index in the form of
13.2 Currency Swaps
dividend and capital is exchanged with either a fixed or floating rate of interest.
It involve an exchange of liabilities between currencies. A currency swap can consist of three
stages:
14. STRATEGIES FOR EXPOSURE MANAGEMENT
 A spot exchange of principal - this forms part of the swap agreement as a similar effect can
A company’s attitude towards risk, financial strength, nature of business, vulnerability to adverse
be obtained by using the spot foreign exchange market.
movements, etc shapes its exposure management strategies. There can be no single strategy
 Continuing exchange of interest payments during the term of the swap - this represents a which is appropriate to all businesses. Four separate strategy options are feasible for exposure
series of forward foreign exchange contracts during the term of the swap contract. The management.
contract is typically fixed at the same exchange rate as the spot rate used at the outset of
the swap.
 Re-exchange of principal on maturity.
 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT 79.41 9.42 STRATEGIC FINANCIAL MANAGEMENT

14.3 High Risk: Low Reward

Perhaps the worst strategy is to leave all exposures unhedged. The risk of destabilization of cash
flows is very high. The merit is zero investment of managerial time or effort.
14.4 High Risk: High Reward
This strategy involves active trading in the currency market through continuous cancellations and
re-bookings of forward contracts. With exchange controls relaxed in India in recent times, a few of
the larger companies are adopting this strategy. In effect, this requires the trading function to
become a profit centre. This strategy, if it has to be adopted, should be done in full consciousness
of the risks.

15. CONCLUSION
Thus, on account of increased globalization of financial markets, risk management has gained
more importance. The benefits of the increased flow of capital between nations include a better
international allocation of capital and greater opportunities to diversify risk. However, globalization
of investment has meant new risks from exchange rates, political actions and increased
Exposure Management Strategies interdependence on financial conditions of different countries.

14.1 Low Risk: Low Reward All these factors- increase in exchange rate risk, growth in international trade, globalization of
financial markets, increase in the volatility of exchange rates and growth of multinational and
This option involves automatic hedging of exposures in the forward market as soon as they arise, transnational corporations- combine to make it imperative for today’s financial managers to study
irrespective of the attractiveness or otherwise of the forward rate. The merits of this approach are the factors behind the risks of international trade and investment, and the methods of reducing
that yields and costs of the transaction are known and there is little risk of cash flow these risks.
destabilization. Again, this option doesn't require any investment of management time or effort.
The negative side is that automatic hedging at whatever rates are available is hardly likely to result TEST YOUR KNOWLEDGE
into optimum costs. At least some management seems to prefer this strategy on the grounds that
an active management of exposures is not really their business. In the floating rate era, currencies Theoretical Questions
outside their home countries, in terms of their exchange rate, have assumed the characteristics of 1. “Operations in foreign exchange market are exposed to a number of risks.” Discuss.
commodities. And business whose costs depend significantly on commodity prices can hardly
2. What do you mean by Nostro, Vostro and Loro Accounts?
afford not to take views on the price of the commodity. Hence this does not seem to be an
optimum strategy. Practical Questions
14.2 Low Risk: Reasonable Reward 1. The price of a bond just before a year of maturity is $ 5,000. Its redemption value is $ 5,250
at the end of the said period. Interest is $ 350 p.a. The Dollar appreciates by 2% during the
This strategy requires selective hedging of exposures whenever forward rates are attractive but
said period. Calculate the rate of return.
keeping exposures open whenever they are not. Successful pursuit of this strategy requires
quantification of expectations about the future and the rewards would depend upon the accuracy of 2. ABC Ltd. of UK has exported goods worth Can $ 5,00,000 receivable in 6 months. The
the prediction. This option is similar to an investment strategy of a combination of bonds and exporter wants to hedge the receipt in the forward market. The following information is
equities with the proportion of the two components depending on the attractiveness of prices. In available:
foreign exchange exposure terms, hedged positions are similar to bonds (known costs or yields)
Spot Exchange Rate Can $ 2.5/£
and unhedged ones to equities (uncertain returns).
 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT 79.43 9.44 STRATEGIC FINANCIAL MANAGEMENT

Interest Rate in UK 12% Spot rate : ` 56.00/£

Interest Rate In Canada 15% Payment date : 3-months
The forward rates truly reflect the interest rates differential. Find out the gain/loss to UK 3 months interest rate : India : 12 per cent per annum
exporter if Can $ spot rates (i) declines 2%, (ii) gains 4% or (iii) remains unchanged over
: UK : 5 per cent per annum
next 6 months.
What should the exporter do?
3. On January 28, 2013 an importer customer requested a Bank to remit Singapore Dollar
(SGD) 2,500,000 under an irrevocable Letter of Credit (LC). However, due to unavoidable 6. The rate of inflation in India is 8% per annum and in the U.S.A. it is 4%. The current spot
factors, the Bank could effect the remittances only on February 4, 2013. The inter-bank rate for USD in India is ` 46. What will be the expected rate after 1 year and after 4 years
market rates were as follows: applying the Purchasing Power Parity Theory.

January 28, 2013 February 4, 2013 7. On April 1, 3 months interest rate in the UK £ and US $ are 7.5% and 3.5% per annum
respectively. The UK £/US $ spot rate is 0.7570. What would be the forward rate for US $
US$ 1= ` 45.85/45.90 ` 45.91/45.97
for delivery on 30th June?
GBP £ 1 = US$ 1.7840/1.7850 US$ 1.7765/1.7775
8. ABC Technologic is expecting to receive a sum of US$ 4,00,000 after 3 months. The
GBP £ 1 = SGD 3.1575/3.1590 SGD 3. 1380/3.1390
company decided to go for future contract to hedge against the risk. The standard size of
The Bank wishes to retain an exchange margin of 0.125% future contract available in the market is $1000. As on date spot and futures $ contract are
quoting at ` 44.00 &` 45.00 respectively. Suppose after 3 months the company closes out
Required:
its position futures are quoting at ` 44.50 and spot rate is also quoting at ` 44.50. You are
How much does the customer stand to gain or lose due to the delay?(Note: Calculate the required to calculate effective realization for the company while selling the receivable. Also
rate in multiples of 0.0001) calculate how company has been benefitted by using the future option.
4. In March, 2009, the Multinational Industries make the following assessment of dollar rates 9. XYZ Ltd. a US firm will need £ 3,00,000 in 180 days. In this connection, the following
per British pound to prevail as on 1.9.2009: information is available:
Spot rate 1 £ = $ 2.00
$/Pound Probability
180 days forward rate of £ as of today = $1.96
1.60 0.15
Interest rates are as follows:
1.70 0.20
U.K. US
1.80 0.25
180 days deposit rate 4.5% 5%
1.90 0.20
180 days borrowing rate 5% 5.5%
2.00 0.20
A call option on £ that expires in 180 days has an exercise price of $ 1.97 and a premium of
(i) What is the expected spot rate for 1.9.2009?
$ 0.04.
(ii) If, as of March, 2009, the 6-month forward rate is $ 1.80, should the firm sell forward
XYZ Ltd. has forecasted the spot rates 180 days hence as below:
its pound receivables due in September, 2009?
Future rate Probability
5. An Indian exporting firm, Rohit and Bros., would be covering itself against a likely
depreciation of pound sterling. The following data is given: $ 1.91 25%
$ 1.95 60%
Receivables of Rohit and Bros : £500,000
$ 2.05 15%
 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT 79.45 9.46 STRATEGIC FINANCIAL MANAGEMENT

Which of the following strategies would be most preferable to XYZ Ltd.? (Price at end - Price at begining)+ Interest
Return =
(a) A forward contract; Price at begining

(b) A money market hedge; (5250 − 5000) + 350

=
5000
(c) An option contract;
250 + 350
(d) No hedging. = =0.12 say 12%
5000
Show calculations in each case
(i) For US investor the return shall be 12% and there will be no impact of appreciation in $.
10. A Ltd. of U.K. has imported some chemical worth of USD 3,64,897 from one of the U.S.
(ii) If $ appreciate by 2% then return for non-US investor shall be:
suppliers. The amount is payable in six months time. The relevant spot and forward rates
are: Return x 1.02 = 0.12 x 1.02=0.1224 i.e. 12.24%
Spot rate USD 1.5617-1.5673 Alternatively it can also be considered that $ appreciation will be applicable to the amount
6 months’ forward rate USD 1.5455 –1.5609 of principal as well. The answer therefore could also be
(1+0.12)(1+0.02) -1 =1.12X1.02 - 1 = 0.1424 i.e. 14.24%
The borrowing rates in U.K. and U.S. are 7% and 6% respectively and the deposit rates are
5.5% and 4.5% respectively. 2.50 (1 + 0.075)
2. Forward Rate = = Can$ 2.535/£
Currency options are available under which one option contract is for GBP 12,500. The (1 + 0.060)
option premium for GBP at a strike price of USD 1.70/GBP is USD 0.037 (call option) and (i) If spot rate decline by 2%
USD 0.096 (put option) for 6 months period.
Spot Rate = Can$ 2.50 x 1.02 = Can$ 2.55/£
The company has 3 choices:
(i) Forward cover £

(ii) Money market cover, and £ receipt as per Forward Rate (Can $ 5,00,000/ Can$ 2.535) 1,97,239

(iii) Currency option £ receipt as per Spot Rate (Can $ 5,00,000/ Can$ 2.55) 1,96,078

Which of the alternatives is preferable by the company? Gain due to forward contract 1,161
(ii) If spot rate gains by 4%
ANSWERS/ SOLUTIONS
Spot Rate = Can$ 2.50 x 0.96 = Can$ 2.40/£
Answers to Theoretical Questions
£
1. Please refer paragraph 8.1
£ receipt as per Forward Rate (Can $ 5,00,000/ Can$ 2.535) 1,97,239
2. Please refer paragraph 2.
£ receipt as per Spot Rate (Can $ 5,00,000/ Can$ 2.40) 2,08,333
Answers to the Practical Questions Loss due to forward contract 11,094
1. Here we can assume two cases (i) If investor is US investor then there will be no impact of (iii) If spot rate remains unchanged
appreciation in $. (ii) If investor is from any other nation other than US say Indian then there
will be impact of $ appreciation on his returns. £
First we shall compute return on bond which will be common for both investors. £ receipt as per Forward Rate (Can $ 5,00,000/ Can$ 2.535) 1,97,239
 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT 79.47 9.48 STRATEGIC FINANCIAL MANAGEMENT

£ receipt as per Spot Rate (Can $ 5,00,000/ Can$ 2.50) 2,00,000 2.00 0.20 0.40
Loss due to forward contract 2,761 1.00 EV = 1.81

3. On January 28, 2013 the importer customer requested to remit SGD 25 lakhs. Therefore, the expected spot value of $ for £ for September, 2009 would be $ 1.81.
To consider sell rate for the bank: (ii) If the six-month forward rate is $ 1.80, the expected profits of the firm can be
maximised by retaining its pounds receivable.
US $ = `45.90
5. The only thing lefts Rohit and Bros to cover the risk in the money market. The following
Pound 1 = US$ 1.7850
steps are required to be taken:
Pound 1 = SGD 3.1575
(i) Borrow pound sterling for 3- months. The borrowing has to be such that at the end of
` 45.90 * 1.7850 three months, the amount becomes £ 500,000. Say, the amount borrowed is £ x.
Therefore, SGD 1 =
SGD 3.1575 Therefore
SGD 1 = `25.9482  3
x 1 + 0.05 ×  = 500,000 or x = £493,827
Add: Exchange margin (0.125%) ` 0.0324  12 

` 25.9806 (ii) Convert the borrowed sum into rupees at the spot rate. This gives: £493,827 × ` 56
= ` 27,654,312
On February 4, 2013 the rates are
(iii) The sum thus obtained is placed in the money market at 12 per cent to obtain at the
US $ = ` 45.97
end of 3- months:
Pound 1 = US$ 1.7775
 3
S = ` 27,654,312 × 1 + 0.12 ×  = ` 28,483,941
Pound 1 = SGD 3.1380  12 
` 45.97 * 1.7775 (iv) The sum of £500,000 received from the client at the end of 3- months is used to
Therefore, SGD 1 =
SGD 3.1380 refund the loan taken earlier.
SGD 1 = ` 26.0394 From the calculations. It is clear that the money market operation has resulted into a
Add: Exchange margin (0.125%) ` 0.0325 net gain of ` 483,941 (` 28,483,941 – ` 500,000 × 56).

` 26.0719 If pound sterling has depreciated in the meantime. The gain would be even bigger.

Hence, loss to the importer 6.

End of Year ` `/USD
= SGD 25,00,000 (`26.0719 – `25.9806)= `2,28,250
1 (1+ 0.08)
4. (i) Calculation of expected spot rate for September, 2009: `46.00 x 47.77
(1+ 0.04)
$ for £ Probability Expected $/£
2 (1+ 0.08)
(1) (2) (1) × (2) = (3) `47.77 x 49.61
(1+ 0.04)
1.60 0.15 0.24
3 (1+ 0.08)
1.70 0.20 0.34 `49.61 x 51.52
(1+ 0.04)
1.80 0.25 0.45
1.90 0.20 0.38
 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT 79.49 9.50 STRATEGIC FINANCIAL MANAGEMENT

4 (1+ 0.08) 1.95 0.04 No 1.99 5,97,000 0.60 3,58,200

`51.52 x 53.50 2.05 0.04 Yes 2.01* 6,03,000 0.15 90,450
(1+ 0.04)
5,94,900
7. As per interest rate parity Add: Interest on Premium @ 5.5% (12,000 x 5.5%) 660
5,95,560
 1 + in A 
S1 = S0  
 1 + in B  * ($1.97 + $0.04)
(d) No hedge option:
 1 + (0.075) × 3 
S1 = £0.7570  12  Expected Future Dollar needed Prob. Pi Pi xi
 1 + (0.035) × 3 
 12  spot rate Xi
1.91 5,73,000 0.25 1,43,250
 1.01875 
= £0.7570   1.95 5,85,000 0.60 3,51,000
 1.00875 
2.05 6,15,000 0.15 92,250
= £0.7570 × 1.0099 = £0.7645
5,86,500
= UK £0.7645 / US$
8. The company can hedge position by selling future contracts as it will receive amount from The probability distribution of outcomes for no hedge strategy appears to be most
outside. preferable because least number of $ are needed under this option to arrange
£3,00,000.
$4,00,000
Number of Contracts = = 400 contracts 10. In the given case, the exchange rates are indirect. These can be converted into direct
$1,000
rates as follows:
Gain by trading in futures = (` 45 – ` 44.50) 4,00,000= ` 2,00,000
Spot rate
Net Inflow after after 3 months = ` 44.50 x ` 4,00,000+ 2,00,000 = ` 1,80,00,000
1 1
GBP = to
` 1,80,00,000 USD 1.5617 USD 1.5673
Effective Price realization = = ` 45 Per US$
$4,00,000
USD = GBP 0.64033 - GBP 0.63804
9. (a) Forward contract: Dollar needed in 180 days = £3,00,000 x $ 1.96 = $5,88,000/-
6 months’ forward rate
(b) Money market hedge: Borrow $, convert to £, invest £, repay $ loan in 180 days
1 1
GBP = to
Amount in £ to be invested = 3,00,000/1.045 = £ 2,87,081 USD 1.5455 USD 1.5609
Amount of $ needed to convert into £ = 2,87,081 x 2 = $ 5,74,162
USD = GBP 0.64704 - GBP 0.64066
Interest and principal on $ loan after 180 days = $5,74,162 x 1.055 = $ 6,05,741
Payoff in 3 alternatives
(c) Call option:
i. Forward Cover
Expected Prem. Exercise Total price Total price Prob. Pi pixi Amount payable USD 3,64,897
Spot rate /unit Option per unit for
in 180 £3,00,000xi Forward rate GBP 0.64704
days
Payable in GBP GBP 2,36,103
1.91 0.04 No 1.95 5,85,000 0.25 1,46,250
 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT 79.51

ii. Money market Cover

Amount payable USD 3,64,897
1 USD 3,56,867
PV @ 4.5% for 6 months i.e. = 0.9779951
1.0225
Spot rate purchase GBP 0.64033
Borrow GBP 3,56,867 x 0.64033 GBP 2,28,512
Interest for 6 months @ 7 % 7,998
-
Payable after 6 months GBP 2,36,510

iii. Currency options

Amount payable USD 3,64,897
Unit in Options contract GBP 12,500
Value in USD at strike rate of 1.70 (GBP 12,500 x 1.70) USD 21,250
Number of contracts USD 3,64,897/ USD 21,250 17.17
Exposure covered USD 21,250 x 17 USD 3,61,250
Exposure to be covered by Forward (USD 3,64,897 – USD USD 3,647
3,61,250)
Options premium 17 x GBP 12,500 x 0.096 USD 20,400
Premium in GBP (USD 20,400 x 0.64033) GBP 13,063
Total payment in currency option
Payment under option (17 x 12,500) GBP 2,12,500
Premium payable GBP 13,063
Payment for forward cover (USD 3,647 x 0.64704) GBP 2,360
GBP 2,27,923
Thus total payment in:
(i) Forward Cover 2,36,103 GBP
(ii) Money Market 2,36,510 GBP
(iii) Currency Option 2,27,923 GBP
The company should take currency option for hedging the risk.

Note: Even interest on Option Premium can also be considered in the above solution.