Chapter: IV Currency Risk Management: The Decision Support System designed for SMEs.

Transcription

1 Chapter: IV Currency Risk Management: The Decision Support System designed for SMEs. The whole concept of risk management with regard to foreign exchange revolves around one concept: that the actual out-turn of a foreign currency transaction needs to be known in advance Francesca Taylor The survey results reveal that there is an absence of any systematic mechanism available with SMEs to recognize their currency risk associated with any particular exposure. The data further reveals that unawareness about the use of derivative products deprives most of the SMEs from availing these currency risk management services. The correlation exercise indicates that there is no single determinant factor that affects the most the exchange rate parity. Factors like sociopolitical changes, war or natural calamities, the central bank s intervention, speculative actions are secondary, it means their effect on the exchange rate can not be measured with statistical tool, while interest rates, inflation and BOP, foreign exchange reserves are primarily responsible factors to determine the exchange rates and are measurable. So the above mentioned secondary factors are assumed to remain constant during this exercise. In order to track the movements of the exchange rates the database of above primary factors is necessary and would go a long way in studying the exchange rate movements. Based on these, the researcher has designed the Decision Support System, particularly for small and medium enterprises who do not have any inbuilt system i.e., forex expertise working for them, hiring services of external agencies or using Reuters would be a costly affair in order to hedge their foreign currency exposures. Thus, the Decision Support System will help them to, 1. Understand their risk. 2. Analyze the market forces. 95

2 3. Measure them correctly. 4. Know-the pay-off profile and then put in place the good risk management policy. 5. Understand products available and use what is best suited to their needs. The Decision Support System so designed by the researcher has following user friendly features - A. The SMEs should maintain a database of inflation, interest rates, BOP and foreign exchange reserve variants of the home country and the trading country for a given period so as to have statistical base in the decision making process and projections. B. The database should be updated at regular intervals of six months since the validity of any transaction according to the exchange control manual provision is for the period of six months. C. The database so maintained should be processed with some decision science tool like SPSS technique as illustrated by the researcher. The SPSS incorporates the use of statistical correlation which is defined as relation between two variables. It is denoted by r. r = Cov (X,Y)/ (SD x * SD y ) The use of SPSS technique thus will help corporates to find out the correlation between the above mentioned variables so as to arrive at the most determinant factor of the exchange rate for the given period. D. The exchange rate volatility trends with the help of the above database and its track record of the percentage change will be helpful to understand the exchange rate volatility. 96

3 E. The volatility so obtained is considered along with the risk bearing capacity of the company. This means in the event of exchange losses, does the company have enough surplus to sustain those losses. For this purpose the researcher has provided a guideline to asses one s risk bearing capacity and that is risk coverage ratio with the help of accounting ratios- CEAT Risk coverage ratio = Cost of Hedging CEAT- Cross-border Earnings after tax The corporates can take the help of their accounts/finance expertise to calculate this ratio before entering into any derivative contract. This risk coverage ratio will guide the SMEs as how many times the cost of hedging is getting covered with the total earnings. If that number turns out to be more, then it indicates that the company has enough surplus to bear the hedging cost. F. The SMEs should find out the percentage share of the volume of cross-border trade out of the total business turnover of the company. This will help the SMEs to recognize the actual currency exposure as follows: If, cross-border trade earnings are > than 50% of the total business turnover, then variations in those earnings will have a sizeable impact on the overall profitability of the company. So such the SMEs have to have the hedging techniques to cover their currency risk. If, cross-border trade earnings are between 25 to 50% of the total business turnover, then also variations in the cross- 97

4 border earnings will have an impact on the overall profit of the company and therefore, company is advised to use the appropriate hedging technique. If, cross-border trade earnings are < 25% of the total business turnover, then the impact whether positive or negative will get absorbed over 75% of the domestic deals, in other words the impact would not affect considerably and so can be ignored. Hence, such SMEs may keep their positions open as the risk coverage ratio mentioned above is sufficient enough to sustain the risk. G. The SMEs should also maintain the track record of Remote Environment comprising of the monetary and fiscal policies and political environment that has direct bearing on inflation, BOP and interest rate which in turn affect the demand and supply of foreign currency flows. For example, the liberalization measures and subsequent removal of trade and capital barrier by Indian govt. led to increase in the GDP and proved as an engine of economic growth and attracted huge foreign funds in to the Indian economy in the form of FDI and FII, thereby increasing the supply of foreign currency which led to the appreciation of rupee. This appreciation of rupee can be well anticipated if corporates keep the track of economic policies. Another example is of liberal remittance facility framed by the RBI, wherein the outflow of foreign currency is permitted to the extent of two lakh dollars. Which in turn resulted into increase in demand for foreign currency in India and thus resulted into appreciation of foreign currency i.e. US Dollar. The corporates are expected to keep track of all such exchange control related measures affecting the inflow and outflow of foreign currency. Thus, the track record of such important events will help the corporates to forecast the possible changes in the exchange rates. H. In addition to above, the corporates are expected to maintain following database- 98

5 1. The portfolio of the cross-border trade transactions undertaken by the corporates should be maintained in such a way that purchase and sale of the foreign currency coincides amount wise and date wise too., i.e., if corporates expects to cover the import bill of say US $ 10,000 falling due on particular date then ensure to have a matching export bill of US $ 10,000 falling due on that date only. 2. The database of major currency movements against Indian Rupee would enable the corporates to know which of these currencies is more volatile in nature which further enables corporates to go for cross-currency options. 3. It has been the practice of the corporates to enter into a long term contracts, say three years. The future price quoted in the contract of such transactions that materialized over a period of three years is really based on current spot rate, thereby giving room for exposure. To avoid this, scientific study of the fluctuations in the exchange rates by extrapolating the six months data for three years would guide corporates in loading the fluctuation factor to the base price. Otherwise as stated above matching liabilities be created. 4. Or if the SMEs enter into the long term contact with the counter party, then it becomes advantageous to put a Price Clause in the contract. Price clause will protect the SMEs from the price fluctuations in the long run. Price movements in either direction more than 10% needs to be taken into consideration and the price of goods will change accordingly. 5. The study of the exchange rate card of the banks displays bill buying rate for various usance period which clearly gives a signal whether currency is going to appreciate or depreciate in near future. If the bank rates show that the foreign currency is at premium or home currency is at discount then the SMEs should go for longer usance period to reduce the exchange rate risk. 6. The data about the forward rates and option prices would also help in understanding the future trend of the currency movements. 99

6 7. The choice of external hedging techniques depends upon the cost bearing capacity of the corporates, as the safest hedging tool i.e. option is relatively costlier on account of upfront premium involved therein. The consideration of the factors listed above would definitely support the SME managers to hedge in more effective manner by selecting appropriate internal/external hedging tool rather than random decision making as has been the general practice followed currently. Thus, analysis carried out on the basis of above parameters would give meaningful results thereby evolving the support system leading to the rational decision making. The database to be maintained by the SMEs is presented in a tabular form below: Table 4.1 Database to be maintained by the SMEs A D E F G H1 H5&6 Data of inflation % Risk interest rates, BOP Change in bearing and forex reserves. the capacity exchange of the rate volatility by compan y the data. % share Track record of the Portfolio Correspondin of the economic and crossborder trade of political events the total turnover. Home Trading Home Trading country Country country country management g data of and diversification bank s exchange rate card. Option prices and future prices given by FEDAI and the RBI This support system would give an indication about the currency movements to the SMEs and is expected to serve as a guiding factor in covering the unavoidable exposures in the cross-border trade transactions. In a way, it will make the SMEs independent to analyze the market forces affecting the exchange rates, will help them to check out 100

7 their position against their currency exposure and take the suitable currency risk management decision accordingly. To make use of the Decision Support System worked out in this research work, an entrepreneur needs to know the foreign exchange derivatives market of India, i.e. available derivative instruments in the Indian foreign exchange market, their functioning, and the RBI guidelines related to them, etc. For this purpose, they will have to read voluminous books to get that information. This is a stumbling block to make use of the Decision Support System, so this ABC manual given below is prepared by the researcher with the help of various books (mentioned in the reference), RBI Circulars and with some hypothetical examples. This manual will help the SMEs to understand the basics of currency derivatives available in the Indian foreign exchange market. ABC Manual of the Indian Foreign Exchange Derivatives Market: A brief history of the currency derivatives market: A derivative instrument is one whose performance is based (or derived), on the behaviour of the price of an underlying asset. The underlying itself does not need to be bought or sold. A premium may be due. (Taylor, 1996) A true derivative instrument requires no movement of principle funds. It is this characteristic that makes them highly useful tools to both hedge and to take risk. Foreign exchange market has shown itself to be a fertile ground for the derivatives techniques. This is because the currency market is huge in terms of trading volumes and small by way of transaction costs. Secondly, it is fully operational for dealing in spot, forwards, or options nearly 24 hours per day, except for weekends and prominent holidays. 101

8 Table 4.2 Global Foreign Exchange Market Turnover: Daily averages in April 2007 in billion of US $ Instrument Spot ,005 transaction Outright Forwards Foreign ,714 exchange swaps Estimated gaps in reporting Total turnover 820 1,190 1,490 1,200 1,880 3,210 Source: the BIS website Derivative instruments are of two types: 1. Traded on the floor of an exchange 2. OTC, i.e. over the-counter market. Today a wide variety of economic entities buys and sells currency derivatives. The array includes investment portfolio managers, mutual funds, private individuals hedge funds, corporate treasurers, exporters and importers and last but certainly not the least, the central bank of the country. Derivative contracts are designed to transfer price risk from a party unwilling to carry it to a party willing to bear it. They can also be used to take highly leveraged speculative bets on the price movements. Like any other contract, there are agreements between two parties- those contracts have price, buyer tries to buy it as cheaply as possible while seller tries to sell it as dearly as possible. So these derivative contracts are simply based on our day to day buyer and seller behavioral pattern. 102

9 There is no end to innovations in the derivative markets. Introduction of credit derivative is relatively new mechanism. More latest is the derivative instruments based on the risk of rainfall, snow, etc. and these types of derivative instruments are sold to event organizers, markets of electricity or ice-creams, etc. Even the macroeconomic variable like inflation is covered under the derivative techniques. (Rajwade, 2004) Evaluation of the foreign exchange derivatives market in India: In India, commodity derivatives like cotton, silver futures have a long history. Financial derivatives are of a recent origin; equity derivatives like futures, options are being traded on NSE and BSE for the last few years. Forwards in the foreign exchange market have been in use since long, while options are quite recent one. As on today, there are as many as 80 banks and financial institutions both Indian and foreign authorized to handle foreign exchange business (FEDAI, see annexure A). The rules for domestic foreign exchange market are covered largely under the Foreign Exchange Management (Foreign Exchange Derivative Contracts Regulations, 2000 (Notification No. FEMA 25 dated ). The various products permitted to be used by residents in India include foreign exchange forward contracts, options both cross-currency as well as foreign currency rupee, and foreign currency-rupee swap. While these products can be used for a variety of purposes, the fundamental requirement is the existence of an underlying exposure to foreign exchange risk. The requirement for qualifying to undertake a hedging transaction in the domestic foreign exchange market is the existence of a crystallized underlying which establishes that the entity has a genuine foreign exchange exposure which is sought to be hedged through the use of these permitted tools. Reserve Bank has in recent times undertaken a series of measures to liberalize the markets further. It was announced in the Annual Policy in April 2007 that SMEs engaged in export-import business will be permitted to hedge their foreign exchange exposures without complying with the 103

10 complicated documentation requirements or past performance of exports and imports. The Annual Policy also permitted resident individuals to book forward contracts on the basis of current or anticipated exposures up to a limit of USD 100,000. Thus, the first step towards liberalization of hedging tools has already been initiated. Foreign Exchange Forwards: Forward foreign exchange contracts are agreements between two parties for the exchange of two currencies on a future date at an exchange rate agreed in the present. For the purpose of hedging foreign exchange exposures particularly by non-financial sector, forward contracts dominate. The technique of forward purchase or sell of foreign currency removes uncertainty as to how much future payables or receivables will be worth in terms of domestic currency. Forwards trade strictly in an over-the-counter market. They have no physical facilities for trading or organized market as such. Standard forward contract maturities are 1, 2, 3, 6, 9 and 12 months. Since it is an over-the-counter product, the size of the contact is tailored to individual needs. A corporate can enter into a forward contract for delivery of say 73 days from the date of transaction; such contracts are known as broken date or odd date contracts. The value dates are obtained by adding the relevant number of calendar months to the appropriate spot value date. For example, for a one month forward transaction entered into on, say, Sept 20 th, the corresponding spot value date is Sept 22 nd and one month forward value date is Oct 22 nd. If any bank holiday occurs on the same day, then the forward contract is shifted to the next eligible business day, like the spot transaction. In case of rolling forward, it should not enter into the next calendar month, hence shifted backward. (Apte, 2002). If the forward price of the currency exceeds the spot price, that currency is said to be at a premium. For example, if the spot rate of sterling in terms of US dollar is Pound sterling 1= US dollar 1.40, while the six month forward price is 1 sterling = 1.45 US dollar. In that case sterling is said to be at a premium against the dollar. On the other hand, if the forward price is less than the spot price, the currency is said to be at a discount. In 104

11 sterling-us dollar case, if the spot rate is sterling 1= US dollar 1.40 and a forward price is sterling 1= US dollar 1.35 means that the sterling is at a discount against the US dollar (correspondingly dollar is at a premium against sterling). With two way quotation, there is no unique way to quantify the discount and premium. So the following formula is used to calculate the premium or discount: [ Forward mid - Spot mid] * 12 * 100 Spot mid With this formula, for any quotation (A/B), a negative answer would indicate that currency A is at a forward premium against the currency B, whereas a positive answer would imply that A is at a forward discount against B. (Apte, 2002) When the forward contract is between two banks, nothing more than a telephonic agreement on the price and amount is required. However, when a bank enters into a forward contract with a non-bank corporation, it will need to protect itself against the possibility that the firm may default on its commitment. So if the firm has a credit line with the bank, the amount involved in the forward contract will get automatically reduced from the credit line. Otherwise, the bank asks the firm to deposit a certain percentage of the value of the contract with the bank. So in case of forward contracts, there is upfront premium or security deposits required, but compensating bank balance is needed. Since the forward sell or purchase of the foreign currency removes the uncertainty about the returns or payables in the future, hedgers will make a appropriate use of the forward contracts, with only one intension to secure the future returns or payables. Speculators have the intension of betting on the forward contract prices and making profits out of those speculative acts. Whereas, arbitragers will arbitrage between various 105

12 assets using forward contracts to take care of the exchange rate risk. This kind of arbitrage is called, Covered Interest Arbitrage, which provides a link between the foreign exchange markets and the money markets in different currencies. The relationship in terms of equality between the forward premium and discount on the one hand and the difference between the two interest rates on the other referred to as, Interest Rate Parity. The premium or discount offsets the difference in the interest rates. Those who believe that the higher risk free return can be earned by converting to a currency that pays a higher interest rate, use interest rate parity theory. (Apte, 2002) For example, suppose a German corporate treasurer wants to earn more than the Germany s interest rate and believes that he can convert DM into dollars and earn higher interest rate prevailing in US. If treasurer does so but fails to arrange the forward contract to guarantee the rate at which the dollars will be converted back to DM. there he runs the risk, not only of not earning less than the US interest rate, but of earning less than the DM rate. Hence the corporate treasurer might wish to lock in the rate at which the dollars can be converted back to DM by selling a forward contract on dollar. This interest rate parity relationship can be described by the following equation for any pair of currencies A and B, ( 1+ ia) F ( A/B ) = ( 1+ ib) S ( A/B ) Here, S = the currency A/B spot rate F = the A/B forward rate ia = annualized interest rate in country A 106

13 ib = annualized interest rate in country B As per our above example, if the German corporate treasurer put DM1 in a n-year DM deposit, at maturity its value will be- DM ( 1 + idm ) If the investor chooses to invest in the US dollar and eliminate all the exchange risk, he/she must do the following: 4. covert DM into dollar spot 5. invest in US dollar deposit 6. sell the dollar proceeds of the deposits forward for the DM At the maturity its value will be- DM ( 1/S ) F ( 1 + ius ) Now suppose these are unequal, i.e. ( 1 + idm ) > ( F/S ) ( 1 + ius ) If it holds, a large number of arbitragers would (assuming no restrictions on fund flows) like to : 1. liquidate dollar deposits or borrow dollars 2. sell dollars and buy DM in the spot market 3. Demand DM deposits and 4. sell DM and buy dollars forwards. Due to this particular action of many investors, market forces will give rise to one or more of the followings: 1. the dollar interest rate, ius rises. 2. dollar depreciate against the DM in the spot market, i.e. S decreases 3. the DM interest rate idm falls 107

14 4. dollar appreciate against the DM in the forward market These changes would force to hold the equality: ( 1 + ia ) F ( A/B ) = ( 1 + ib ) S ( A/B ) So it becomes an equilibrium relationship. It only says that annualized premium or discount in the foreign exchange market should equal the interest rate differential in the market. (Rajwade, 2004) In India, Authorised Dealers (Category I) are permitted to issue forward contracts (all public sector banks, private banks and foreign banks come under the category I, all co-operative banks under category II and selective financial institutions like EXIM bank come under the III category of the Authorised Dealers as per the Reserve Bank.) to person resident in India with crystalised foreign currency/ foreign interest rate exposure is based on the past performance/ actual import-export turnover, as permitted by the Reserve Bank and to persons resident outside India with genuine currency exposure to the rupee as permitted by the Reserve Bank. The residents in India generally hedge crystallized foreign currency/ foreign interest rate exposure or transform exposure from one currency to another permitted currency. Residents outside India enter into such contracts to hedge or transform permitted foreign currency exposure to the rupee, as permitted by the Reserve Bank. (RBI Master Circular, 2006) In India the domestic money market is distinct from the foreign exchange market. Foreign exchange has been kept in separate water tight compartment away from the rupees. The forward margin in the Indian foreign exchange market, instead of being determined by interest differentials is a function of demand and supply (Machiraju, 1998). The Sodhani Group (1995) identified the reserve requirement as the major impediment for the development of term inter-bank money market and recommended that it should be lifted. The group has suggested that commercial banks should be permitted to deposit/ borrow short term 108

15 dollars abroad, subject to limits specified by the RBI. Unless these prerequisites are met, forward exchange rate will not be determined by the principle of interest rate parity. Currency Options: An option is a financial contract in which a buyer of the option has the right to buy or sell an asset, at a pre-specified price, on or up to a specific date, (Apte, 2004). If the option buyer chooses to buy or sell an asset, however, there is no obligation as such to do so, in that case the seller of the option has an obligation to take the other side of the transaction. The option buyer can simply lapse his right by not exercising his option. Here, the option buyer has to pay the option seller a fee for receiving such privilege. Option contracts are available for the large variety of the assets, namely, stocks, currencies, debt instruments, and even commodities, and this derivative tool has proved to be a very versatile and flexible tool for the risk management purpose. Options on stock indices and future contracts and future style options are trade on the organized exchange, while overthe-counter option trading has had a long history. Option trading on organized option exchanges is relatively recent. Options on spot exchange are traded in the OTC markets as well as a number of organized exchanges, namely, 1. The United Currency Options Market of the Philadelphia Stock Exchange. 2. The London Stock Exchange. 3. The Chicago Board Options Exchange. Options on currency futures are traded at the Chicago Mercantile Exchange (CME) and the LIFFE 9 Some of the terms commonly used in the option market are: 9 Detail information about each exchange is available on its individual exchanges web site or on 109

16 Writer/Seller of the option: The party who has the obligation to buy or sell the asset underlying the contract, at the agreed price and time, if the option is exercised by the option buyer. Buyer of the option: The party who has the right, but not the obligation, to sell/buy the asset underlying the contract at the agreed price and time. Types of Options: 1. Call Option: The right to buy an asset. 2. Put Option: The right to sell an asset. 3. American Option: An option, which can be exercised at any time until the expiry date. 4. European Option: An option, which can be exercised only on expiry. 5. Bermudan Option: An option, which is exercisable only during a predefined portion of its life. Strike Price/ Exercise Price: The price specified in the option contract at which the option buyer can purchase the currency (call) or sell the currency (put) against the other currency. It is the rate of exchange between two currencies that applies to the transaction if the option buyer decides to exercise his/her option, and its not the price of the option. Option Premium/ Option Price: The fee that the option buyer must pay to the option seller up-front at the time the contract is initiated. It is not refundable, whether the option is exercised or not. At-the-money, in-the-money and out-of-the money option: The pattern of the above any option depends upon the difference between the strike price and the current market exchange rate, i.e. spot rate. For example: the call option is said to be at-the-money if the spot rate and strike price are equal. It is said to be in-the-money, if the spot rate is greater than the strike price and out-of-the-money is called, when the spot rate is lower than the strike price. Opposite is in the case of put option. 110

17 Call Option: - Put Option: - 1. S = X At-the-money 2. S > X In-the-money 3. S < X Out-of-the-money 1. S = X At-the-money 2. S > X Out-of-the-money 3. S < X In-the-money Intrinsic Value of the Option: Intrinsic value is the profit available on the immediate exercise of the option. Time Value of the Option: The difference between the option premium and the intrinsic value, reflecting the value arising from the time left until its expiry. (Apte,2004) Other than future, Option is also a derivative tool, wherein a trader can make lots of permutations and combinations just to make profit if the underlying price moves in a certain fashion. They are called spread strategies. Spread strategies involve simultaneous sell and purchase of the two different option contracts. Following are some of the spread strategies with options: 1. Bullish/Vertical Spread: consists of selling the call with the higher strike price and buying the call with the lower strike price. This type of spread is very frequently traded, by those who has bullish as well as cost saving attitude. If the trader expects that the price will not rise beyond certain limits, he/she tries to reduce the cost by selling the call. Here, he/she has limited his looses as well as gains, but he/she has leveraged his returns. A bullish put spread is buying puts at a lower price and selling them at the higher price. Here, if there is a significant appreciation, put will not be exercised and the net gain will equal the difference in premiums. However, if there is a significant depreciation, maximum loss will be difference in the strike price minus the difference in premiums. 111

18 2. Bearish/ Spread: Bearish call/put spreads are just opposite to bullish call/put spreads respectively. These strategies involving options with same maturity but different strike prices are called vertical or price spreads. Trader who is not expecting the price to rise very much and fall very much will go for bearish call spread. 3. Horizontal or Time Spread: Horizontal spreads are simultaneous purchase and sell of two options identical in all respects except the expiry date. The idea behind it is that the time value of the short term maturity option will decline faster than the time value of the long term maturity option. This is because the premium of the option increases as the maturity period increases. The difference in premiums between two options will be moderate at the time of initiation, but will widen at the time of expiry of the short term option, assuming that the exchange rate has not moved drastically. 4. Butterfly Spreads: Here, either call or put options with three strike prices- For example: X1 500 X2 550 X3 600 And the purpose behind it is to buy two call options with middle strike price i.e. 550 and writing one call each with strike price on either side, i.e., 500 and 600. Selling a butterfly spread involves selling two intermediate priced calls and buying one on either side. One who expects the exchange rate of the particular currency to remain in a particular range, goes for this type of spread. 5. Straddles and Strangles: A straddle is done by buying a call and a put, both with identical strike prices and maturities. If there is a drastic depreciation, gain is made on the put while in case of drastic appreciation, the call gives the profit. For moderate movements, a net loss results. Strangle is similar to straddle. It is like buying a call with strike price above the current spot rate and a put with strike price below 112

19 the current spot rate. It gives net gains for the drastic movements of the spot, and a loss for moderate movevements. Both straddles and strangles are bets on changes in exchange rate volatility, i.e. the volatility of the spot rate is going to increase and one is betting on that. (Apte,2004) 10 The Reserve Bank of India in 1994 permitted Ads (category I) to issue cross-currency options to a person resident in India with a genuine foreign currency exposure. Before the introduction of options the corporates were permitted to hedge their foreign currency exposures through forwards and swaps route. Forwards and swaps do remove the uncertainty by hedging the exposure but they also result in eliminating the potential extraordinary gains from the currency position. The clients use this instrument to hedge or transform foreign currency exposure arising out of the current account transactions. ADs use it to cover the risks arising out of market-making in foreign currency rupee options as well as the cross-currency options, as permitted by the RBI. These contracts are allowed with certain RBI regulations: 1. the currency option can be used as a hedge for foreign currency loans provided that the option does not involve rupee and the face value does not exceed the outstanding amount of the loan. 2. such contracts are allowed to freely rebooked and cancelled. 3. Banks can also purchase call or put options to hedge their crosscurrency proprietary trading positions. ADs (category I) approved by the Reserve Bank of India to sell foreign currency rupee options to their customers on a back-to-back basis, provided they have a capital to risk weighted assets ratio (CRAR) of 9% or above. These options are used by customers who have genuine foreign currency exposures. Introduction of this particular option proved to be 10 Many books mainly deal with stock options but contain a substantial amount of material that is relevant to currency options. Some of them are Ritchken (1987) and Hull (2000). The monograph by Bodurtha and Courtadon (1987) deals exclusively with currency options. 113

20 beneficiary to importers, exporters and for hedging balance sheet exposures. (RBI Master Circular, 2006) 11 Currency Swaps: The term swap implies a temporary exchange of one currency for another, with an obligation to reverse it at a specific future date. A swap transaction in the foreign exchange market is a combination of a spot and a forward in the opposite direction. Following examples illustrate the swap transactions: a. Bank buys US $ 1 million spot and simultaneously sells US $ 1 million one month forward. b. Bank sells US $ 1 million spot and simultaneously buys US $ 1 million two months forward. c. Bank buys 2 million Euros one month forward and simultaneously sells 2 million Euros two months forward. d. Bank sells pound sterling 1 million three months forward and simultaneously buys 1 million pound sterling two months forward. In all the above transactions same amount of a foreign currency is being bought and simultaneously sold or vice-versa for different value dates, these are swap transactions. In transaction 1 and 2, the value dates are spot/forward. However, in 3 and 4 value dates are forward/forward, such transactions are know as forward to forward swap. Generally there is only one counter-party in the swap deal and bank receives or pays the forward differentials depending upon the swap differentials and currency being at a premium or discount. It is very important to note here that the swap rate is not an exchange rate, it is an exchange rate differential. It is the difference which buyer/seller has to pay/receive for swapping spot against forward or forward against forward (Bhardwaj, 1994). 11 Copy of the RBI Mater Circular No./06/ on Risk Management and Inter Bank Dealings, is attached in Annexure

21 A typical swap quotation appears as follows: US$/CHF spot: / month swap: 15/8 The swap quotation is given such that the last digit coincides with the same decimal place as the last digit of the spot price. This means that the swap price is quoted in points or pips. Thus, in the US$/CHF quote given above, the numbers 15/8 mean CHF /CHF To arrive at the implied outright forward, the swap margins must be added to or subtracted from the corresponding side of the spot quotation. Thus in the above example, must be added to or subtracted from the spot bid rate of and must be added to or subtracted from the spot ask rate But whether to add or subtract based on two principles: 1. The bank must always make profit, i.e. the rate at which bank sells a currency must exceed the rate at which it buys the same currency. Hence the outright forward ask rate must exceed the bid rate. 2. As a general rule, the bid-ask spread widens as we go farther and farther into the future. It is narrowest for the spot, narrower for 1- month forward than for 3-month forward and so forth. This is so because as maturity increases, the volume of turnover declines and counterparty credit risk increases. Based on these principles, if swap points are low/high, one has to add those points and if swap points are high/low, subtract swap points. In case of above example of US$/CHF swap points are high/ low, so we need to subtract those points from the spot rate. Then we get the 1-month swap rate as / Here both the principles are fulfilled. A person resident in India, who has a foreign exchange or rupee liability, may enter into a contract for Foreign Currency-Rupee Swap with an AD bank in India to hedge long term exposure under the following terms and conditions: I) No swap transactions involving upfront payment of rupees or its equivalent in any form shall be undertaken. 115

22 II) Swap transactions may be undertaken by AD banks as intermediaries by matching the requirements of corporate counter-parties. III) While no limits are placed on the AD banks for undertaking swaps to facilitate customers to hedge their foreign exchange exposures, limits have been put in place for swap transactions facilitating customers to assume a foreign exchange liability, thereby resulting in supply in the market. While matched transactions may be undertaken, a limit of USD 50 million is placed for net supply in the market on account of these swaps. Positions arising out of cancellation of foreign currency to rupee swaps by customers need not be reckoned within the cap. IV) With reference to the specified limits for swap transactions facilitating customers to assume a foreign exchange liability, the limit will be reinstated on account of cancellation/ maturity of the swap and on amortization, up to the amounts amortized. V) The above transactions if cancelled shall not be rebooked or reentered, by whatever name called. Currency Futures: A future contract is a standardized contract, traded on an exchange, to buy or sell an asset at a certain time in the future for a certain price, (Hull, 2003). Where the underlying asset happens to be a commodity, the futures contract is termed as commodity futures whereas in cases where the underlying happens to be a financial asset or instrument, the resultant futures contract is referred to as financial futures. A currency futures contract, also called an FX future, is a type of financial futures contract where the underlying is an exchange rate. There are many exchanges throughout the world trading futures contracts. Considering the international experiences and the current stage of development of the foreign exchange market in India, the Report of the Internal Working Group on Currency Futures, RBI, recommended the introduction of currency futures in the domestic foreign exchange market. 116

23 As regards the underlying, since the futures contract is aimed at participants seeking to hedge their foreign exchange exposure, the most liquid onshore currency pair, viz. USD-INR was considered as an eligible underlying and exchange traded currency derivatives made a hesitant beginning in the second half of Average turnover of these instruments in the National Stock Exchange and MCX Stock Exchange (MCX-SX) in December 2009 was nine times higher than a year earlier. These exchanges are currently clocking an average daily turnover of over Rs. 20,000 crore in currency products. Later based on the market feedback and experiences gained, the introduction of other currency pairs happened in February 2010, i.e., the rupee against euro, yen and pound. A day after the introduction of the new currency pairs, they clocked a volume of Rs. 1,277 Cr. On the NSE. MCX-SX have also registered a turnover of around 2,700 Cr., out of which Rs.1, Cr. in INR/Euro pair, Rs Cr. in INR/GBP pair and Rs Cr. in INR/JPY pair. Table 4.3 The contract specifications are summarized below in tabular form: Category Description 1. Underlying Rate of exchange between one US $ and INR 2. Contract Size USD Contract Months 12 near calendar months 4. Expiration date and time Last Business day of the month 5. Minimum Price fluctuations 0.25 paise or INR Settlement Cash settled in INR based on Reserve Bank reference rate of expiry date 7. Margins As specified by the clearing corporation Source: RBI report on Currency Futures, 2008, 117

24 Eligible Participants: The requirement of an underlying exposure to trade in OTC foreign exchange market is very difficult to implement in an exchange- traded regime. Participation in the currency futures market may initially be restricted to residents alone in the interest of financial stability. This is suggested purely from the perspective of ascertaining the robustness of various systems such as surveillance, monitoring, reporting etc. Further, no quantitative restrictions may be imposed on residents to trade in currency futures. This is likely to ensure greater liquidity and wider participation and would be in line with usual policy where liberalization is done first for residents. As regards non residents, the participation may be permitted in a gradual and phased manner. Once the currency futures market systems stabilise, including execution procedures, risk management framework and surveillance mechanism, participation of Foreign Institutional Investors (FIIs) and Non Resident Indians (NRIs), as hedgers through designated AD banks may be permitted. (RBI Report, April 2008) An interesting comparison between India s OTC market and recently developed Currency futures market was made by the National Stock Exchange in one of its seminar on creating awareness about the currency futures exchange among the SMEs. Table 4.4 Comparison between OTC Market and Currency Futures. OTC Market Currency Futures Price Transparency Low, bilateral contracts with banks. High, online-real time screen. Liquidity Subject to credit limit Margins equate all participants. Settlement Full notional, unless Net settled in INR cancelled Credit Exposure Exposure to your counter party (bank) Clearing Corporation guarantees all trades. 118

25 Execution Only by ADs 500+ trading members, including banks. Margins/ MTM Nil (if any critical situation, like recession margins are high) Margins and MTM are mandatory. Source: The need for introduction of currency futures was viewed in the context that wider hedging opportunities could strengthen economic agents' ability to cope with market-induced currency movements. This decision will provide trading and settlement infrastructure and regulatory framework and other aspects to create an enabling environment for players in the Indian foreign exchange market. 119

26 Working on hypothetical examples:- The above part helps us in understanding the conceptual part of the derivative tools. To make it more simplified from the layman s point of view, the researcher tried to use some hypothetical examples. The basic idea behind it was to prove that any corporate, instead of keeping its position open in the foreign exchange market; it is always beneficial to cover itself with the help of the hedging techniques. Though sometime keeping your position open turns out to be the best decision, but this doest not happen always. Those hypothetical examples were worked on the following basis: The call and put option prices are calculated as per the equations given in the International Financial Management book by P.G. Apte. European Call Option Formula: C(t) = S(t) B F (t,t) N (d 1 ) - XB H (t,t) N (d 2 ) In ( SB F / XB H ) + (σ 2 / 2) T d 1 = σ T In ( SB F / XB H ) ( σ 2 / 2) T d 2 = σ T European Put Option Formula: P(t) = XB H (t,t) N (D 1 ) S (t) B F (t,t) N (D 2 ) = B H (t,t) [ XN (D 1 ) F t, T N (D 2 ) ] Where, D 1 = - d 2 and D 2 = - d 1 S = the current spot rate 120

27 X = the exercise price t = the current time T = time to maturity σ = the standard deviation of log-changes in the spot rate B H = home currency price of discount bond B F = foreign currency price of discount bond N(d) = the standard normal cumulative distribution function 1. An Indian firm has US $ 20 million receivables within a 1- month period. The current spot rate i.e. on 7 th Nov After a month the spot rate is Open Position Receivables Spot rate after one month Final amount to be received. 20,000,000 US $ USD/ INR 762,650,000 Rs. 2. Forward Cover Receivables 1-month forward premia+ current spot rate= Forward rate Final amount to be received. 20,000,000 US $ = ,400,000 Rs. 3. Option cover Receivables X-St* 20 mn US $ + St* 20 mn US $ - put option Final amount to be received premium paid* 20 mn US $ = Final receivables 20,000,000 US $ ( ) ($ 20 mn) + ( ) ($ 20 mn) (0.2183)($ 20 mn) = 771,634,000 Rs. 771,634,000 Rs. Here, St<X, i.e < , so if we compare only spot market and option market, then the put option buyer will exercise the option, since the received dollars can be sold at a higher price in the option market only. 121

28 If, after a month spot rate appreciates, = Open Position Receivables Spot rate after one month Final amount to be received. 20,000,000 US $ USD/ INR 750,000,000 Rs. 2. Option cover (X-St)* (20 mn US $) + (St)* (20 mn US $) (put option premium paid)* (20 mn US $) = Final receivables. i.e. ( ) ($ 20 mn) + (37.50) ($ 20 mn) (0.2183)($ 20 mn) = 771,634,000 Rs. And if Spot rate depreciates, = Open Position Receivables Spot rate after one month Final amount to be received. 20,000,000 US $ 39 USD/ INR 780,000,000 Rs. 2. Option cover Since St > X, (St-X)* (20 mn US $) + (St)* (20 mn US $) (put option premium paid)* (20 mn US $) = Final receivables. i.e. ( ) ($ 20 mn) + (39) ($ 20 mn) (0.2183)($ 20 mn) = 779,634,000 Rs. 122

29 2. An Indian software firm with substantial exports to US is expecting an inflow of US $ 200 million in six months time. The current spot rate i.e. on 22 nd Nov After six months the spot rate is Open Position Receivables Spot rate after six month Final amount to be received 200,000,000 US $ ,042,500, Forward Cover Receivables 6-month forward premia+ current spot rate= Forward rate Final amount to be received 200,000,000 US $ = ,713,440, Option cover Receivables X-St* 200 mn US $ + St* 200 mn US $ -put option premium Final amount to be received paid* 200 mn US $ = Final receivables 200,000,000 US $ ( ) (200mn US $) + ( ) (200 mn US $) (0.5605) (200 mn US $) = 7,687,900,000 7,687,900,000 Here, St<X, i.e <39, so the put option buyer will exercise the option, since received dollars can be sold at a higher price offered in the option market. Currency Futures: Case 1: View: INR will depreciate against USD, caused by India s sharply rising import bill and poor FII inflows. Trade: INR/USD 31 July 08 contract : Current spot rate (9 July 08) : Buy one July contract : Value Rs. 43,500 (USD 1000* ) Hold contract to expiry : RBI fixing rate on 29 July Economic return : Profit- Rs. 500 (44,000-43,500) 123

30 Case 2: Expecting a remittance for USD 1000 on 29 August 08. Want to lock in the forex rate today. Trade: INR/USD 29 Aug 08 contract : Current spot rate (9July 08) : Sell 1 Aug contract : Value Rs. 44,250 Expiry date : RBI fixing rate on 27 Aug Sell USD 1000 in the spot OTC market at Economic return : Profit- Rs 250 (44,250-44,000) effective rate on remittance while spot on that date was Case 3: Investment offshore for USD 1000 on 31 July 08. Also want to keep forex exposure hedge for a month after that. Trade: INR/USD 31 July 08 contract : INR/USD 29 Aug 08 contract : Current spot rate (9 July 08) : Buy 1 July contract : Sell 1 Aug contract : Expiry of July contract : RBI fixing rate on 29 July Buy USD 1000 in the spot OTC market at invest Off Shore Expiry of Aug contract : Sell off-shore investment RBI fixing Rate on 27 Aug Sell USD 1000 in spot OTC market at Economic return : July contract: Rs. 500 (44,000-43,500) August contract : Rs. 250 (44,250-44,000) 124