Forex Exposure Management

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FOREX EXPOSURE MANAGEMENT
TABLE OF CONTENTS
RUDIMENTS OF FOREIGN EXCHANGE 7

1.1 FOREIGN EXCHANGE-INTRODUCTION7
1.2 THE NEED FOR FOREIGN EXCHANGE 7
1.3 CAN THE TRANSACTION BETWEEN TWO COUNTRIES BE SETTLED IN
A 3RD COUNTRY? 8
1.4 FOREIGN EXCHANGE MARKET 8
1.5 PARTICIPANT OF FOREIGN EXCHANGE MARKETS 8
1.6 TYPES OF DEALING IN THE LOCAL FOREIGN EXCHANGE MARKETS
10
1.7 FACTORS THAT CONTRIBUTE TO THE GROWTH OF INDIAN FOREX
MARKETS 11
OVERVIEW OF FOREIGN TRADE 15
ORGANISATIONAL SET UP OF M/S CIBA SPECIALTY CHEMICALS INDIA LTD

17
1.8 INTRODUCTION 17
1.9 BACKGROUND 19
FOREX MANAGEMENT POLICY 20

1.10 PREQUISITES 20
1.11 ANALYSIS 20
1.12 CONCEPT OF GROSS EXPOSURE AND NET EXPOSURE 21
1.13 FRAMING A POLICY 21
1.14 PERFORMANCE EVALUATION CRITERIA 23
1.15 FOREIGN EXCHANGE RISK MANAGEMENT POLICY OF M/S CSCIL
23
1.16 RISK MEASUREMENT APPROACH 24
1.17 TYPES OF FOREIGN EXCHANGE RISKS 25
1.18 RECOGNITION OF EXCHANGE RISKS 26
1.19 FOUR STEPS IN RISK MANAGEMENT 27
1.20 POSSIBLE PERFORMANCE EVALUATION CRITERIA AT M/S CSCIL:
31
1.21 CONCEPT TRANSFER PRICING 33
1.22 PERIOD OF MEASUREMENT 34
1.23 NET POSITION 34
1.24 EXHIBIT-1: FOREX RATES & EXPOSURES 34
1.25 MATURITY MISMATCH OR GAPS 35
STRUCTURE OF LIMITS 38
1.26 OVERALL LIMITS 38
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1.27 INDIVIDUAL DEALER LIMITS 38
GUIDELINES FOR RISK MANAGEMENT 40

1.28 HEDGING 40
1.29 PASSIVE RISK MANAGEMENT 40
1.30 ACTIVE RISK MANAGEMENT 41
VALUATIONS OF FOREIGN EXCHANGE EXPOSURES 42
INTERNAL CONTROLS 43
1.31 BALANCE OF PAYMENT 44
1.31.1 SOME BASIC CONCEPTS 44
1.32 COMPONENTS OF BALANCE OF PAYMENTS: 45
1.32.1 Current account 45
1.32.2 Trade flows 45
1.32.3 Invisibles 46
1.32.4 Deficit & Surplus 46
1.32.5 Capital Account 48
THE MANAGEMENT OF FOREIGN EXCHANGE RISK 49

1.33 OVERVIEW 49
1.34 SHOULD FIRMS MANAGE FOREIGN EXCHANGE RISK-HOW? 50
1.35 ECONOMIC EXPOSURE, PURCHASING POWER PARITY & THE
INTERNATIONAL FISHER EFFECT 52
1.36 FOREIGN EXCHANGE FORECASTING 52
1.37 HISTORICAL PERSPECTIVE ON EXCHANGE RATE, GOLD STANDARD
53
1.37.1 Gold standard 53
1.37.2 Definition of Arbitrage 54
1.37.3 Bretton Wood’s System 54
1.38 FEATURES OF EXCHANGE RATE SYSTEM 55
1.38.1 Collapse of Bretton Woods System (1944 to 1971) 55
1.39 FLOATING EXCHANGE RATE SYSTEM 56
1.40 OBJECTIVES OF LIMITED FLEXIBILITY SYSTEM 56
1.41 CRAWLING PEG (GLIDING PARITIES) 56
1.42 MIXED SYSTEM 56
1.43 EXCHANGE RATE ARRANGEMENTS 56
1.44 MARKET SIZE 57
1.45 MECHANICS OF EXCHANGE RATE 57
1.46 IDENTIFYING EXPOSURE 59
1.47 METHOD FOLLOWED BY US COMPANIES 61
1.48 EXPOSURE - TYPES AND DESCRIPTION 66
1.49 MANAGING ECONOMIC EXPOSURE 67
1.50 STEPS IN MANAGING ECONOMIC EXPOSURE 68
1.51 GUIDELINES FOR CORPORATE FORECASTING OF EXCHANGE RATES
70
1.52 TOOLS AND TECHNIQUES FOR THE MANAGEMENT OF FOREIGN
EXCHANGE RISK 73
FOREIGN EXCHANGE MARKET 73

1.53 STRUCTURE OF THE FOREX MARKET: 73
1.54 MARKET PLAYERS: 74
1.55 MECHANICS OF CURRENCY TRADING: 74
1.56 TYPES OF TRANSACTIONS AND SETTLEMENT DATES: 74
1.57 ARBITRAGE BETWEEN BANKS: 75
1.58 INVERSE QUOTES AND 2-POINT ARBITRAGE 76
1.59 OUTRIGHT FORWARD QUOTATIONS 76
1.60 DISCOUNTS AND PREMIA IN THE FORWARD MARKET 76
1.61 ANNUALIZED PREMIUM / DISCOUNT: 77
1.62 MARGIN REQUIREMENT: 77
1.63 FORWARD CONTRACTS, FUTURES & CURRENCY OPTIONS 77
1.63.1 Forward Contract 77
1.63.2 Currency Futures 78
1.63.3 Debt instead of forwards or futures 79
1.63.4 Currency Options 80
1.63.5 Swap 81
1.63.6 Cross Rates 82
1.63.7 Controlling Corporate Treasury Trading Risks 82
1.64 MARKET FORECASTS 83
1.65 MARKET PARTICIPANTS 84
1.66 MARKET PARTICIPANTS - 4 CATEGORIES 84
1.67 HEDGE FUNDS 84
1.68 DEALING ROOMS 84
1.69 INFORMATION SYSTEMS 85
1.70 PAYMENT AND COMMUNICATION SYSTEM 85
1.71 RISK APPRAISAL 85
1.72 BENCHMARKING 86
1.73 HEDGING 87
1.74 STOP LOSS 88
1.75 REPORTING AND REVIEW 89
1.76 CONCLUSION 91
LATEST IN FOREIGN EXCHANGE - TECHNOLOGY ADVANTAGE 91
RESREVE BANK OF INDIA REGULATIONS & DEFINITIONS 95

1.77 SHORT TITLE & COMMENCEMENT 95
1.78 DEFINITIONS 95
1.79 SUMMARY OF EXCHANGE RATE REGIME IN INDIA 96
1.80 EXCHANGE RATE CALCULATIONS 96
1.81 MULTI CURRENCY OPTION 97
FROM THE ILLUSTRATION - LESSONS TO BE LEARNT 98

INFORMATION ON EURO 99
1.82 EVOLUTION OF EURO MARKET 99
1.83 WHAT ARE EURO MARKETS? 99
FOREX MARKET IN INDIA 101
BIBLIOGRAPHY & LIST OF REFERENCES 103
RUDIMENTS OF FOREIGN EXCHANGE
1.1 Foreign Exchange-Introduction
Foreign Exchange, simply stated, means foreign money. Thus, foreign exchange and near
money instruments denominated in foreign currency, are called foreign exchange. In
other words, all claims to foreign currency payable abroad, whether consisting of funds
held abroad in foreign currency or bill or cheques in foreign currency etc., fall in the
category of foreign exchange.
In India, foreign exchange has been given a statutory definition:
Def: Sec 2(b) of Foreign Exchange Regulation Act, 1973 states:
“Foreign Exchange” means foreign currency and includes:
1. all deposits, credits and balances payable in any foreign currency and any drafts,
traveler’s cheques, letter of credit and bills of exchange, expressed or drawn in Indian
currency but payable in any foreign currency
2. any instruments payable, at the option of drawee or holder thereof or any other
party thereto, either in Indian currency or in foreign currency or partly in one and partly
in the other.
1.2 The need for Foreign Exchange
An example in this aspect would be apt to understand the need of Foreign Exchange.
A Japanese company exports electronic goods to USA and invoices the goods in US
Dollars. The American importer will pay the amount in US dollars, as the same is his
home currency. However, the Japanese exporter requires Yen i.e. his home currency for
procuring raw material locally and making payments for the labour charges incurred for
the purpose etc.
Thus, he would need exchanging US dollars for Yen. If the Japanese exporter invoices
his goods in Yen, then importer in USA will get his dollars converted in Yen and pay the
exporter. And therefore, it can be inferred that in case goods are bought or sold outside
the country, exchange of currencies becomes necessary.
1.3 Can the transaction between two countries be settled in a 3rd Country?
Yes, it is also possible that the transactions between two countries might be settled in the
currency of third country.
Ex:
An Indian exporter, exporting goods to Singapore may raise an invoice for the goods sold
in US dollars and as the importer in Singapore has to make payment in US dollars and as
the importer in Singapore has to make payments in US dollars, he will have to exchange
his Singapore dollars into US dollars. The Indian exporter on receipt of US dollars will
exchange them into Indian Rupees. Thus, as in this case, the transaction may give rise to
exchange of currencies in the exporter’s country as well as the importer’s country. Such
transaction may give rise to conversion of currencies at two stages.
1.4 Foreign Exchange Market
Foreign Exchange market is in fact misnomer or misleading in as much as there is no

market place as such which can be called foreign exchange market. However, it is a
facilitating mechanism through which one country’s currency can be exchanged i., e
bought or sold for the currency of another country. It does not have any geographic
location. The foreign exchange market comprises of all the foreign exchange traders who
are connected to each other throughout the world through telecommunication network.
They deal with each other through telephones, telexes, and electronic systems. With
advent of advanced technology like Reuters Money 2000-2, it is possible to access any
trader in any corner of the world within a few seconds. In fact now deal can be done
through electronic dealing systems that allow bid and offer rates to be matched
automatically through central computers and thus transaction take place in jiffy.
1.5 Participant of Foreign Exchange Markets
Any one who exchanges the currency of one country for currency of another country or
needs such services is said to participate in foreign exchange markets. The main players
in the foreign exchange markets are:
a. Customers
The customers who are engaged in foreign trade participate in foreign exchange
markets by availing of the services of banks, like an exporter or importer. Also services
may be required for settling any International obligations i.e., payment of technical
know-how fees or repayment of foreign debt etc.
b. Commercial Banks
Commercial banks dealing with international transactions offer services for

conversion of one currency into another. They are the most active players in forex
market.
c. Central Banks
The central banks, in most of the countries, have been charged with the
responsibility of maintaining the external value of the currency of the country. If the
country is following a fixed exchange rage system then the central bank has to take
necessary steps to maintain the parity i.e., the rate so fixed. Even under the floating
exchange system the central bank has to ensure orderliness in the movement of exchange
rates. This is achieved by central bank’s intervention in the forex market. Apart from
intervention the Central bank deal in the foreign exchange markets for the purpose of:
• Exchange rate Management
Sometimes it is achieved thru the intervention yet where a Central Bank is required to
maintain external rate of the domestic currency at a level or in a band so fixed, they deal
in the market to achieve the desired objective.
• Reserve Management
Central Bank is predominantly concerned with investment of countries foreign exchange
reserves in fairly stable proportions in range of currencies, and in a range of assets in
each currency. These proportions are, inter-alia, influenced by the structure of official
external assets/liabilities. The process of reserve management inevitably involves a
certain amount of switching between currencies.
d. Exchange Brokers
In India dealing is done in inter bank market through forex brokers. Similarly, in London,
New York and Paris inter bank transactions are put through forex brokers. However, in
India the A Ds are free to deal directly among themselves without going through brokers.
The forex brokers are not allowed to deal in their own account all over the world and also
in India.
e. Speculators
Major chunk of the foreign exchange dealings in the forex market is on account of
speculators and speculative activities.
Banks do the same in view to make profit on account of favorable movement in exchange
rates, take positions, i.e. if they feel that rate of a particular currency is likely to go up in
short term then they buy currency and sell it as soon as they are able to make quick
profits.
Corporations-MNCs & TNCs having business operations beyond their national frontiers
and on account of their cash flows being large and in multi currencies get into foreign
exchange exposures. With a view to take advantage of the exchange rate movements in
their favor they either delay covering exposures or do not cover until cash flows
materialize. Sometimes they take positions so as to take advantage of the exchange rate
movement in their favor and for undertaking this activity they have state of art dealing
rooms.
As the exchange controls have been loosened, in India also some of the big corporates are
booking and canceling forward contracts and at times the same borders on speculative
activity.
1.6 Types of dealing in the local Foreign Exchange Markets
• Merchant Transaction
When authorized dealers buy/sell foreign exchange from/to exporter/importers and other
customers then it’s called a merchant transaction. This transaction can be undertaken only
on account of genuine exposure of the customers and speculation is prohibited. These
merchant can book, re-book, cancel forward contracts with Authorised Dealers with
respect to their genuine foreign exchange exposure. This facility was available to
residents only. However, RBI has loosened the grip further and allowed NRIs/FIIs also to
book forward contract for certain accounts/investments by them in India.
• Inter-Bank Transaction
When one bank deals with another bank i.e. buys/sells foreign exchange, it is known as
inter bank dealing. The banks in India are allowed to deal freely amongst themselves.
Most of the banks are not market makers and rather they are market users. Thus, there is
not much liquidity and depth in the foreign exchange market in India and the market
notices even the small demand or supply. After Rupee has joined the freely floating
currencies there are days when exchange rates in inter bank markets have been very
volatile and RBI has been forced to intervene in the market almost on regular basis,
particularly during such periods.
• Overseas Transaction
When a bank in India buys/sells foreign exchange in the overseas foreign markets then it
is called an overseas transaction. The banks in India can cover its positions arising out of
merchant transactions or inter bank dealings freely in overseas exchange market. RBI has
also permitted banks on a selective basis to initiate positions overseas.
• Transaction between Banks and RBI
After introduction of Modified Liberalized Exchange Rate Management System

(Modified LERMS) and on account of amendment to Section 40 of RBI Act, 1934, RBI
is not obliged to sell foreign exchange but buys foreign exchange offered to it buy A Ds
at market related rates. Therefore, RBI has discontinued, w.e. f Oct 4th 1995, the practice
of announcing its two way exchange rates. However, the RBI has been invested with the
right to intervene in the market as and when necessary and it intervenes in its wisdom it
deems fit. In fact RBI has been buying foreign exchange when there was excess supply in
the market. RBI has also been intervening in the market through Spot, Forward & Swaps
quite often after the Rupee started floating, so called, freely.
1.7 Factors that contribute to the growth of Indian Forex Markets
Global Forex market has taken quantum jump and the Indian market has followed suit.
Better communication network like telephones, telexes, SWIFT, Reuters/Telerate system

etc., have been made available to the forex dealers and these have contributed to the
speed and efficiency of the market. Thus, they are able to generate larger turnover.
Rigid and tight exchange controls have been relaxed and the banks are completely free to
deal in the inter bank market as also, to some extent, in the overseas market.
With opening up of the banking sector to private sector more players have been added to
the market. Also, many more foreign banks have set up shops in India and those, which
were already operating, have established more branches. This has contributed to higher
foreign exchange turnover.
Banks have been allowed to have, albeit to a small extent, an access to the foreign
currency assets and liabilities. With limited integration of Indian and overseas forex
markets, banks have access to the inter bank markets for conversion of forex funds into
Indian rupees and re-conversion of the same on a continuous basis has given the fillip in
the market.
The Liberalised Exchange Rate Management System and freedom given to the corporates
to book, re-book and cancel forward
contracts so long they have the genuine exposure, have also contributed to the increased
inter-bank dealings and consequently increase in the trading volume in the foreign
exchange markets.
• Types of currencies traded in Indian Market
The major currencies being traded in the Indian Forex market are US dollar, Pound
Sterling(GBP), Deutsche Mark(DEM), Japanese Yen(YEN), French Franc(FRF), Swiss
Franc(CHF), Italian Lira(ITL) etc. The market also trades in exotic currencies like
Middle East currencies. The EURO is a new single currency used by most of the nations
of the Western Europe. It will gradually replace national currencies such as German Mark
or the French Frank etc. Thus, Euro will also play a major role as far trading in India in
concerned.
• Growth of forex market over the years
The forex market is the world's largest financial market, with $1.4-trillion in transactions
daily. The turnover in the Indian forex market has also been increasing over the years.
The average daily gross turnover in the dollar-rupee segment of the Indian forex market
(merchant plus inter-bank) was in the vicinity of US$ 3 billion during 1998-99. The daily
turnover in the merchant segment of the dollar-rupee segment of foreign exchange market
was US$ 0.7 billion, while turnover in the inter-bank segment was US$ 2.3 billion. The
average daily turnover in the spot market was around US$ 1.2 billion and in the forward
and swap market, the daily turnover was US$ 1.8 billion during 1998-99.
• FEDAI's role in the forex market
Foreign Exchange Dealers Association of India (FEDAI) sets the ground rules for
fixation of commissions and other charges, and also involves itself in matters of mutual
interest of the Authorised Dealers. FEDAI also accredits brokers through whom the
banks put through deals.
• Authorised dealers in foreign exchange

RBI may, on an application made to it in this behalf, authorise any person to deal in
foreign exchange or in foreign securities, as an authorised dealer, money-changer or off-
shore banking unit, or in any other manner as it deems fit.
Generally, authorisations, in the form of licenses, to deal in foreign exchange, are granted
to banks, which are well equipped to undertake foreign exchange transactions in India.
Authorisations have been given to certain financial institutions to undertake specific
types of foreign exchange transactions incidental to their main business, which are also
called `restricted authorised dealers'.
• Rupee quoted against Dollar
In India, we follow a direct exchange rate quote which gives the home currency price of a
certain amount of the foreign currency quoted, i.e. the amount of foreign currency is
fixed and the amount of home currency keeps varying with the change in exchange rate.
This, however, is not the only method of quoting the exchange rate; banks in Great
Britain quote the value of the pound Sterling in terms of the foreign currency, which is
called the ìndirect exchange rate quote'. The form of quoting Pound sterling, Euro and
Australian Dollar is called indirect quote because GBP has always been stronger than
USD, even Euro started as a stronger currency than USD and Australian Dollar is the
commonwealth currency so it has to follow the path of GBP.
• Activities that can possibly carry foreign exchange exposure
Foreign exchange exposures arise from many different activities. A traveler going to visit
another country has the risk that if that country's currency appreciates against their own,
their trip will be more expensive.
Similarly, an exporter who sells his/her product in a foreign currency faces the risk that if
the value of the Indian rupee appreciates vis-à-vis dollar, his revenue in terms of the
Indian rupee, nose-dives.
An importer, who buys goods priced in foreign currency, faces the risk that the rupee
might depreciate against the dollar, thereby making the local-currency cost of the imports
greater than expected.
• Authorised money-changers and the powers they are they vested with
The Reserve Bank of India has empowered certain people, i.e. shops, emporia, travel
agents, etc., to deal in foreign currency, subject to certain restrictions. They are not
allowed to deal in foreign exchange; rather they are supposed to play the role of
facilitators for undertaking the function of money changing. They are required to provide
facilities for encashment of foreign currency to visitors from abroad, especially foreign
tourists.
They can be classified into two categories, i.e., full-fledged money-changers who can
undertake both purchase and sale transactions with the public, and restricted money-
changers who are authorised only to purchase foreign currency notes, coins and travelers
cheques, subject to the condition that all such collections are surrendered by them in turn
to an authorised dealer in foreign exchange/ full-fledged money-changer.
• Has the Reserve Bank permitted exchange brokers to operate in the foreign
exchange market?
Yes, the Reserve Bank of India has stated that there is no objection to employment of
brokers, but in all cases, their principal as well as the brokers must comply with the
requirement of the exchange control. Exchange brokers are, however, not authorised to
deal in foreign exchange on their own account, hence, they should not purchase or sell
foreign exchange from/to the public.
• Does a customer, i.e. an importer, exporter or any other person, have the liberty to
enter into a trade contract in whichever currency he or she desires?
The Reserve Bank of India has not placed any restrictions on any foreign currency being
chosen for trade purposes, but the EXIM policy stipulates that all export contracts and
invoices shall be denominated in permitted currencies only, i.e. freely convertible foreign
currency.
OVERVIEW OF FOREIGN TRADE
Any business is open to risks from movements in competitors' prices, raw material prices,
competitors' cost of capital, foreign exchange rates and interest rates, all of which need to
be (ideally) managed.
These Risk Management Guidelines are primarily an enunciation of some good and
prudent practices in exposure management. They have to be understood, and slowly
internalised and customised so that they yield positive benefits to the company over time.
It is imperative and advisable for the Apex Management to both be aware of these
practices and approve them as a policy. Once that is done, it becomes easier for the
Exposure Managers to get along efficiently with their task.
The efforts of globalization of Indian economy have set a new pace to foreign trade.
Further, the advent of economic reforms, liberalisation, deregulation & the process of
opening up the economy to global players had a far-reaching impact on foreign trade.
Capital flows across nations have registered a quantum leap with the removal of rigid
exchange controls by many nations and the consequent increase in cross-border trade.
The impact of these developments is visibly obvious in the developing nations.
It can be observed that foreign trade constituting exports and imports were USD 46391
Mio in the year 1990-91 which increased to USD 73872 Mio in 1995-96 and
subsequently to 107456 Mio in 1999-00. It is also encouraging that the exports now
finance over 78 percent of imports compared to only about 60 percent in the latter half of
the eighties. India’s export performance grew by 11.5 PA; almost double that of world
exports which grew by 5.6 percent. Similarly, the quantified export growth was 20
percent in 1996-97, 18 percent in 1997-98 & 21 percent in 1998-99. Measured by all
standards India’s foreign trade definitely entered as fast track in the new global trajectory.
Therefore, the demands on Public Sector Banks (PSBs) too increased in the area of
handling international trade and related services.
While the expansion in economic activities in various other sectors could be handled by
emerging new financial institutions and non-banking financial institutions, the
requirements of foreign trade, international settlement of transactions, global funds
transfer and other exotic services related to Foreign Exchange (FX) transactions need to
be routed through the authorised dealers. Therefore, the pressure for service centers more
on the selected authorised branches of PSBs and EXIM bank.
But, on the other hand, the infrastructure to handle foreign trade in Public Sector Banks is
growing at a lesser pace than the pace of growth of foreign trade, which often creates a
vacuum impinging the quality of services. The attempt of PSBs to cope with growing
demand is transparent.
The opening of specialised FX desk in branches, the proliferation of dedicated overseas

business branches, mechanisation of operations, introduction of new range of
products/services etc. are certainly the manifestation of PSBs to meet the needs of
increasing foreign trade entrepreneurs.
These large increases in foreign trade by India are having its effects directly or indirectly
on every organisations. The reduction of import duty tariffs is exposing domestic
organisations to the global environment. Domestic organisations are now restructuring
their business to take advantage of lower imports in order to produce more competitive
finished goods.
Similarly, reduced costs and incentives provided by the Government to promote exports
attracts the domestic organisations to export trade.
This new environment has forced the organisations to participate in foreign trade, which
in turn has led them to face new foreign currency exposure. In the succeeding sections,
we shall see more of M/s CSCIL, its policies for handling its Foreign Trade Exposures
and other related matters of Foreign Trade, and managing of foreign exchange exposures.
ORGANISATIONAL SET UP OF M/S CIBA SPECIALTY CHEMICALS INDIA LTD

1.8 Introduction
M/s CSCIL was incorporated in the year 1975 on the 1st of July with an authorised Share
Capital of 10000000 Equity Shares of Rs.100/- each amounting to Rs.10 Crore. Issued,
Subscribed and Paid-up share capital amounted to Rest. 5 Cores made up of 500000
equity shares of Rs.100/- each with 51% foreign stake. The Parent Company of Ciba
Specialty Chemicals Inc. is based in Basle, Switzerland. It is a multi-segment; multi
product range is now diversified into the following areas:
1. Plastic Additives
2. Coating Effects
3. Water & Paper Treatment
4. Textile Effects
5. Home & Personal Care
With respect to the exposures in Foreign Currency, the Company has exposures in respect
of:
1. Imported Raw Materials & Capital Goods

2. Exports
3. Royalty Payments
4. Technical Know-how Fees
5. Commission in respect of Exports
6. Dividend Remittance
7. Income from Research & Development Services rendered
The figures for last 5 years in relation to imports & exports have been tabulated below
and also presented graphically. It is observed that M/s CSCIL is a net importer and,
therefore, its policy is based on imports. Exports are, therefore, considered as an internal
hedge, subject to mismatches of maturity dates. It is important to note here that any
adverse impact of rupee depreciation or devaluation will have a favourable impact on
exports and vice versa.
Now, moving onto a sound risk management policy vis-à-vis the policy of M/s CSCIL
the following graph will make an attempt to understand how each of the above mentioned
exposures are managed.
IMPORTS OF CSCIL IN THE LAST 5 YEARS
Year 95-96 96-97 97-98 98-99 99-00

Rs.Crores 15.23 20.48 36.76 62.40 83.96
EXPORTS OF CSCIL IN THE LAST 5 YEARS

Year 95-96 96-97 97-98 98-99 99-00

Rs.Crores 22.97 63.52 89.13 64.49
164.95
1.9 Background
Liberalisation of Indian Economy coupled with lowering of import tariffs on one hand
and thrust on exports on other hand has resulted into significantly higher transactions
denominated in foreign currency for many Corporates. Up to 1992, for a long time,
Indian Rupee was continuously but steadily depreciating against major foreign
currencies. Forex Management was relatively easier, as steady decline of Indian Rupee
was more or less matched by the forward cover premiums.
The year 1992 saw Indian Rupee being officially devalued by more than 10% in 8 days
time. This was followed by huge inflow of foreign currency in the country. The huge
inflows were not only due to increase in exports, but also due to Foreign Direct
Investments (FDI) and Portfolio investments by Foreign Institutional investors. As a
result, the USD vis-à-vis Rupee rate was rock steady at about Rs.31.40 - 45 for more than
30 months. However, during this period also, USD suffered a setback of more than 20%
between May 1994 to August 1994 against European currencies and Yen. Indian Rupee
is linked to other currencies through USD. Therefore, it also depreciated by 20% against
European currencies and Yen.
Thus, during a period of unprecedented steady Rupee against USD faced substantial
volatility. Also Corporates having exposure to other foreign currencies had to face the
same.
In the recent past alone, Indian Rupee first depreciated against USD by more than 20%
and then recovered by about 7%. USD has appreciated by a range of 10 - 15% against
European currencies and Yen.
All this brings about the importance of active Forex management by Corporates. This
paper attempts to explain all the important parameters of active Forex management. It is
broadly divided into five major sections viz:
• Forex Management Policy

• Treasury Performance Evaluation Criteria
• Policy and Performance evaluation of derivative products
• Managing External Commercial borrowings
• Concept of Transfer Pricing
FOREX MANAGEMENT POLICY

1.10 Pre-requisites
It is said that whatever gets measured gets managed better.
The first step in this direction is having a clear forex management policy. A detailed and
well laid down policy should determine authority and responsibility of various people
involved in the process. Ideally, Corporate Finance should be responsible for Forex
Management, as finance people are more aware of forex risk and closer to bankers who
offer forex hedging products as well as settle all forex transactions. The process is
followed sequentially as shown below:
DEPT/ACTIVITY DEPT/ACTIVITY EXPOSURE RESULT

1 Purchase Dept/ Import Order Finance Dept/Forex Policy (Norms) Forward
Contract cover Full/Part Execution of Order ?
2 Sales Dept/ Exporter Order Finance Dept/Forex Policy (Norms) Keep part or
full exposure open Sales Realisation ?
It is absolutely essential that the import and export order should clearly state the
currency, shipment schedule, payment terms etc. It’s recommended that the exposure
should be recognised with only on receipt of a complete import or export order.
The following cash flows/ transactions are considered for the purpose of exposure
management.
Variable / Cash Flows Transaction Type

Contracted Foreign Currency Cash Flows
Foreign Interest Rates, whether Floating or Fixed
Cash Flows from Hedge Transactions
Projected/ Contingent Cash Flows Both Capital and Revenue in nature
All Interest Payments/ Receipts
All Open hedge transactions
Both Capital and Revenue in nature
• Cash Flows above $100,000/- in value will be brought to the notice of the
Exposure Manager, as soon as they are projected.
• It is the responsibility of the Exposure Manager to ensure that he receives the
requisite information on exposures from various sections of the company in time.
1.11 Analysis
These exposures will be analysed and the following aspects will be studied:
? Foreign Currency Cash Flows/ Schedules

? Variability of Cash flows - how certain are the amounts and/ or value dates
? Inflow-Outflow Mismatches / Gaps
? Time Mismatches / Gaps
? Currency Portfolio Mix
? Floating / Fixed Interest Rate ratio
1.12 Concept of Gross Exposure and Net Exposure
Some managements look at imports and exports separately and, therefore, treat the
exposures separately. Some are more particular where some imports are made towards
export order & therefore, net forex inflow against forex outflow.
There are certain limitations of looking at Net Exposures:
• The period of inflow and outflow may not match;

• The currency of inflow and outflow may be different;
• Cancellation or postponement of an import or export order may result into
substantial change in risk profile.
This is the reason why exposure of imports and exports should be managed separately.
1.13 Framing a Policy
Forex policy will reflect the management philosophy to the risk. It should clearly state
the risk the management is willing to take and the delegation of authority, to various
people.
The policies have been discussed followed by many Corporates and recommendations of
leading forex consultants. Practically, all of them recommend a range between 25% to
75% for forward covers.
It means that the values covered should never be below 25% of the exposure & not
beyond 75% of the exposures.
A slightly different but more practical approach to this is shown below:

a) Operational or Treasury Department Level:
COVER
(MINIMUM) COVER
(MAXIMUM)
1 For professionally managed and/or some what aggressive Organisation
35% 65%
2 For Organisations who do not have proper set up or those who are risk averse
45% 55%
b) Top management level

(Owner/Managing Director/ Head of Finance)
COVER
(MINIMUM) COVER
(MAXIMUM)
1 For professionally managed and/or somewhat aggressive Organisation
25% - 35% 65%-75%
2 For organisation who do not have a proper set up or those who are risk averse
25%-45% 55%-75%
Top Mangement’s decision should always be based upon input and recommendations of
either the operations level management or Banks or Consultants. It should always be
recorded in writing.
We will observe that the arithmetic mean of minimum cover and maximum cover is 50%.
This is same as the probability of getting head or tail when we toss a coin. Here there is a
question. Is there any logic in keeping the mean at 50%?
The answer is Yes. We will see this in our next section.
1.14 Performance Evaluation Criteria
Very few organisations have an elaborate forex policy. Even among those, very few have
performance evaluation criteria. Why?
• One major problem is that of a having reasonable and rational performance

evaluation criteria.
• The second problem could be the efforts required to evaluate the performance. A
major factor could also be the fear of a bad performance. This issue is attacked first as it
helps prepare ground for our recommendations towards the end of this section.
Consider following factors:
1. Forex business exceeds USD 1000 billion every day. There are many large
players trying to outperform each other.
2. Forex market has rarely responded to basic fundamental factors in short to

medium terms. Short to medium term refers to a period of 1 week to 6
months. Most of the corporate exposures will be for this period.
3. When USD started depreciating against Yen and European currencies in 1994-95,
even intervention by 12 central banks of most powerful nations in the world could not
arrest the dollar fall.
4. Like any other market, forex is a zero sum game. Rewards normally depend upon
the risk one is taking.
In view of the above, it’s recommended that any performance, which is even slightly
above average, should be acceptable. Its advised not to set very ambitious performance
criteria, as this may result into total failure of the system or taking up of undue risk by the
Treasury Manager.
1.15 Foreign Exchange Risk Management Policy of M/s CSCIL

Importance:
Any institution exposed to risk on account of foreign exchange exposure should maintain
written policies and procedures that clearly outline its risk management strategy. These
policies will help the institution in managing the impact of exchange rate/ interest rate
fluctuations on its profit and loss account and its balance sheet. The foreign exchange
policy is also based on and in consistency with the organization’s broader business
strategies, capitalization and loss bearing capacity, management expertise and corporate
philosophy on risk taking in this area. This policy seeks to establish a sound and
appropriate risk management process.
The primary components of the risk management process are:
• A comprehensive risk management approach

• A details structure of limits
• Guidelines and other parameters used to govern risk management
• A strong management information system for controlling, monitoring and
reporting risk.
In the light of the above, we shall study, in detail the primary components of risk
management process at CSCIL.
The Board of Directors has approved the Foreign exchange risk management guidelines.
The senior management is responsible for ensuring that procedures exist is followed
strictly for conducting transactions on a day-to-day basis. Also, the reporting and
measurement in terms of exposure for risk management is adhered to.
Responsibility for daily currency risk management activities is concentrated in a central

Treasury Function. The Corporate Treasurer is responsible for defining and managing the
net currency exposure and gaps or maturity mismatches of the company from the
exposures and gaps of the various individual units of the company. Responsibility for
reporting risk exposures to senior management is with a unit independent of the treasury
function to ensure that control and policy compliance objectives are met.
1.16 Risk Measurement Approach
A sound risk measurement should identify
? the various types of foreign exchange risks that the institution is exposed to
(which has been listed in the earlier pages)
? the point of recognition of these risks
? the period of measurement.
Using these, the Corporate Treasurer defines the net position and gaps/maturity of the
company.
1.17 Types of Foreign Exchange Risks
A foreign exchange risk can be defined as the net effect of rate fluctuations on the Profit
& Loss Account (P&L) and on the Balance Sheet position.
In this context a foreign exchange risk impacting the P&L Account would arise on
account of:
1 Imports of raw materials/exports of goods

2 Availment of buyers/suppliers credits
3 Sundry remittances of royalty/traveling expenses etc
4 Principal amount of foreign exchange loan repayment
5 Interest payments on outstanding foreign exchange loans
6 Translation of financial statements of offshore branches/subsidiaries incorporated
overseas
7 Depreciation on fixed assets financed through foreign exchange loans
A foreign exchange risk impacting the Balance Sheet (B/S) would be:
? Imports of fixed assets financed though foreign exchange loans

? Approvals for foreign exchange loans (loans pending draw-down)
Also important to note is the risk on account of interest rate fluctuations in the case of
loans/borrowings/lendings etc. These also need to be addressed by an institution as they
can be optimally managed with the use of derivatives such as Interest Rate Swaps,
Forward Rate Agreements etc.
Volumes of foreign exchange exposures at CSCIL as at 31/03/01 are listed below:
Nature of Exposures Amount PA

(Rest in Mio)
Imports 1719
Exports 1631
Royalty 3
Technical Know How Fees 0
Indent Commission 2.3
Dividend @ 50% p.a. 24
Income from Research and Development 0
1.18 Recognition of Exchange risks
There are theoretically a number of alternatives when a company should recognise the
existence of a foreign exchange exposure.
I. At the time of Budgeting

II. At the time of raising import orders/receiving export orders/approvals of foreign
exchange loans
III. At the time of shipment of goods/draw down of loans
IV. On due date of payment
In order to be proactive in managing foreign exchange exposures, recognise a foreign

exchange risk from the time of budgeting as this would be the earliest point in time where
an exposure can be recognised. However, the variations in the estimation of budgets may
have a serious impact on the profitability of a company and, therefore, M/s CSCIL
recognises its exports and covers the same only on raising of import order in the case of
imports and on receipt of a confirmed export order in the case of exports or on approval
for foreign exchange loans.
Secondly, the company should also factor in that all budgeted items will not necessarily
fructify. As regards its other exposures, the same are recognised as and when they
arise/on due dates. It is important to note here that certain foreign exchange remittances
may not really involve risk to to the remitter.
For example, M/s CSCIL remits dividends, royalty and technical know-how fees to its
parent company, M/s CSC Inc., Basle, in Switzerland based on certain factors like
dividend is paid at the rate declared on equity of the company and equivalent USD or
CHF (Swiss Francs) is remitted. Similar is the case of technical know how fees and
royalty remittances as the same are paid as a percentage on sales.
However, these payments needs to be managed as it would yield better results or higher
remittances to the Parent Company with a limited liability on M/s CSCIL.
1.19 Four Steps in Risk Management
1. Understand the nature of various risks.

2. Define a risk management policy for the organization and quantifying maximum
risk that organization is willing to take if quantifiable.
3. Measure the risks if quantifiable and enumerate otherwise.
4. Build internal control mechanism to control and monitor all the risks.
Step 1 – Understanding Risks
Risks can be classified into five categories:

1. Price or Market Risk
2. Counter party or Credit Risk
3. Dealing Risk
4. Settlement Risk
5. Operating Risks
1. Price Risks or Market Risk

This is the risk of loss due to change in market prices. Price risk can increase further due
to Market Liquidity Risk, which arises when large positions in individual instruments or
exposures reach more than a certain percentage of the market, instrument or issue. Such a
large position could be potentially illiquid and not be capable of being replaced or hedged
out at the current market value and as a result may be assumed to carry extra risk.
2. Counter party Risk or Credit Risk
This is the risk of loss due to a default of the Counterpart in honouring its commitment in
a transaction (Credit Risk). If the Counterparty is situated in another country, this also
involves Country Risk, which is the risk of the Counter party not honouring its
commitment because of the restrictions imposed by the government though counter party
itself is capable to do so.
3. Dealing Risk
Dealing Risk is the sum total of all unsettled transactions due for all dates in future. If the
Counter party goes bankrupt on any day, all unsettled transactions would have to be
redone in the market at the current rates. The loss would be the difference between the
original contract rate and the current rates. Dealing risk is therefore limited to only the
movement in the prices and is measured as a percentage of the total exposure.
4. Settlement Risk
Settlement risk is the risk of Counterparty defaulting on the day of the settlement. The
risk in this case would be 100% of the exposure if the corporate gives value before
receiving value from the Counterparty. In addition the transaction would have to be
redone at the current market rates.
5. Operating Risks
Operational risk is the risk that the organization may be exposed to financial loss either
through human error, misjudgment, negligence and malfeasance, or through uncertainty,
misunderstanding and confusion as to responsibility and authority.
Further operating risks could be classified as under:
• Legal
• Regulatory
• Errors & Omissions
• Frauds
• Custodial
• Systems
Legal
Legal risk is the risk that the organisation will suffer financial loss either because
contracts or individual provisions thereof are unenforceable or inadequately documented,
or because the precise relationship with the counter party is unclear.
Regulatory
Regulatory risk is the risk of doing a transaction, which is not as per the prevailing rules
and laws of the country.
Errors & Omissions
Errors and omissions are not uncommon in financial operations. These may relate to
price, amount, value date, currency, and buy/sell side or settlement instructions.
Frauds
Some examples of frauds are:
• Front running
• Circular trading
• Undisclosed Personal trading
• Insider trading
• Routing deals to select brokers
Custodial
Custodial risk is the loss of prime documents due to theft, fire, water, termites etc. This
risk is enhanced when the documents are in transit.
Systems
Systems risk is due to significant deficiencies in the design or operation of supporting
systems; or inability of systems to develop quickly enough to meet rapidly evolving user
requirements; or establishment of a great many diverse, incompatible system
configurations, which cannot be effectively linked by the automated transmission of data
and which require considerable manual intervention.
Step 2 - Define Risk Policy

Decide the basic risk policy that the organisation wants to have. This may vary from
taking no risk (cover all) to taking high risks (open all). Most organisations would fall
somewhere in between the two extremes. Risk and reward go hand in hand.
Cost Center Vs. Profit Center
A cost center approach looks at exposure management as insurance against adverse
movements. One is not looking for optimisation of cost or realisation but meeting certain
budgeted or targeted rates. In a profit center approach, the business is taking deliberate
risks to make money out of price movements.
Step 3- Risk Measurement
There are a number of different measures of price or market risk which are mainly based
on historical and current market values Examples are Value at Risk (VAR), Revaluation,
Modeling, Simulation, Stress Testing, Back Testing, etc.
Step 4- Risk Control
Control of Price Risk
Position limits are established to control the level of price or market risk taken by the
organization.
Diversification is used to reduce systematic risk in a given portfolio.
Control of Credit Risk
Credit limits are established for each counter party for both Dealing Risk and Settlement
Risk separately depending upon the risk perception of the counter party.
Control of Operating Risk

Establishment of an effective and efficient internal control structure over the trading and
settlement activities, as well as implementing a timely and accurate Management
Information System (MIS).
Tools to control operating risks
• Comprehensive Systems and Operations Manuals
• Proper Organizations structure and adequate personnel
• Separation of trading function from settlement, accounting and risk control
functions.
• Strict enforcement of authority and limits
• Written confirmation of all verbal dealings
• Voice recording
• Legally binding agreements with counter parties ensuring proposed transactions
are not ultra vires.
• Contingency Planning
• Internal Audits
• Daily reconciliations
• Ethical standards and codes of conduct
• Dealing discipline
1.20 Possible performance evaluation criteria at M/s CSCIL:
1. Spot rate on settlement date
Actual rate of remittance is compared against spot rate on settlement date. As a

result, performance of uncovered transactions is “Average” or “0” in mathematical terms.
Thus, only performance of covered transactions gets reflected in this type of evaluation.
Moreover, throughout the exposure period, there is no target for the Treasury Manager.
2. Forward rate on date of exposure
In this method, “Forward Rate” quoted for the expected date of settlement is taken
as standard for evaluation of performance. Since this rate is known from day one, there is
certainly a target for the Treasury Manager. However, in this case, performance of
covered transactions will be “0” or average. Thus, only performance of uncovered
transactions gets judged. Therefore, this method is also not desirable.
Both the above methods suffer from one major limitation. They have no reference to the
forex policy of the organisation. To elaborate, in case of 1st method, if the rupee is not
expected to depreciate to the extent of premium, the Treasury Manager would like to
keep all the import transactions uncovered and cover all the export transactions.
Similarly, when he expects rupee to depreciate beyond the premium levels, he would like
to cover all the import transactions and keep open all the export transactions. What one
must find out is whether the policy permits taking such steps? Can a policy afford to be
so flexible? If not, then a Treasury Manager has no authority to take such extreme
positions. And when he cannot take position as per his views, can he be made
responsible for that position?
To take a concrete example, if we are following:
Method 1: Treasury Manager will incur loss on covered transaction for imports (and
uncovered export transactions), if rupee is steady vs. premium. Since the policy requires
certain minimum cover, Treasury Manager will attribute the losses to the policy.
Method 2: Similarly, if we are following this method and say Rupee depreciates beyond
premium, the Treasury Manager will incur loss on uncovered import and covered exports.
Again he will attribute it to policy. In short, f the Treasury Manager cannot take a
decision to keep uncovered 100% transactions or cover 100% transactions; he cannot be
expected to perform as per either Method 1 or Method 2. Therefore, a more practical
method is recommended.
Method 3: 50% at forward rate on date of exposure and 50% at settlement date rate, for
each transaction. This method has following advantages:
I) For 50% of the amount of each transaction, there is a clear target, while for
remaining 50%, the Treasury Manager will have to be really alert, watchful and use his
knowledge and experience of market.
II) In method 1, performance of uncovered items does not get evaluated, while in
method 2, performance of covered item does not get evaluated. However, in method 3,
performance of both covered and uncovered transactions gets evaluated (though only to
the extent of 50%).
III) Normally any policy will allow taking cover up to 50% and keeping 50% open.
Therefore, Treasury Manager will have full authority to reach a position, which is in line
with performance measurement criteria. Therefore, he cannot attribute anything to rigid
forex policy.
In view of the above, I am of the opinion that method III is most balanced and acceptable
way of performance evaluation.
An imaginary but realistic situations have been taken and the performance is calculated
under various methods. The results of the same are given in the annexure. I am sure that
the example clearly brings out limitation of the first two methods and advantages of
method III.
1.21 Concept Transfer Pricing
Some company’s follow the concept of transfers pricing for forex transactions viz.
imports and exports. In this concept, the operating divisions and Finance agree on a
budget rate of exchange at the beginning of a period, generally a financial year. During
the whole year, the transactions are passed on to the divisions at the agreed transfer price
rate. The difference between actual rate and transfer price is borne by Finance
Department. According to advocates of this concept, it helps operating divisions to meet
the budgeted targets, as they are assured of a certain rate for forex. However, there is a
major practical difficulty in this concept.
Suppose for 1997-98, we have agreed on a transfer price @ 1 USD = Rs.37/-. Let us
assume that some divisions are importing finished goods costing USD 10 per kg. The
product is sold in the market at Rs.400/- per kg. Now, suppose the USD/Rupee rate goes
to Rs.41/- by June 1997. If the division still continues to import the material (as it can get
USD at Rs.37/- being agreed rate with Finance), the division will make a profit of Rs.30/-
per kg. Finance losses will be Rs.40/- per kg. The Company as a whole will lose Rs.10/-
per kg. Is this situation acceptable? The reality is that operating or business divisions
must accept that there could be changes in cost of inputs or sales realisation due to
changes in exchange rate. As a matter of fact, can some one guarantee purchase or sale
price even for local materials? Just because there is an added element of exchange rate
fluctuation, business divisions cannot pass it on entirely to finance.
The best way to handle this kind of situation is to have a continuous communication
between Finance and business divisions. Depending on level of forex business, Finance
Division should send weekly or fortnightly information about spot and forward rates for
major currencies to business divisions. Based on this, business divisions should take
their decisions and inform the exposure to Finance as early as possible. In exceptional
cases, if there is any large import or export order with a very small margin, business
division may insist on 100% cover specifically. Such requests should be accepted by
Finance. However, in such cases, there should be no performance evaluation of such
transactions, as the forward cover was business decision and not a finance decision.
In summary, it’s recommended that:
I) there should be well laid down forex policy, separately for imports and exports.
The policy should be reviewed every year.
II) There has to be performance measurement criteria, giving weightage to both

forward rate on date of exposure and spot rate on settlement date.
III) Transfer pricing concept should be avoided as far as possible. However, specific
covers for large transactions may be taken as a business decision.
1.22 Period of Measurement
An institution would also need to define the time period over which exposure must be
managed. For example, exposure up to 1 year or till the financial year-end. However, as
recommended that an exposure should be recognised at the time of budgeting. The period
of measurement should coincide with the budgeting period. In case of CSCIL, the
FOREX risks are measured to a period of 1 year.
1.23 Net Position
Using these above criteria the Corporate Treasurer defines the new position if the
Company. For this purpose, the company distinguishes between the USD/INR and the
cross currency exposure for every item independently as the local market in India
determines the USD/NSR rate only and the cover on any other currency is possible
through its cross with USD/INR. This differentiation is important as it enables the
company to match or offset exposures effectively and the hedging strategy for the crosses
would be different as compared to that of the USD/INR.
The General Manager Finance to the Managing Director reports the net position on a
weekly basis. Statistically, it’s shown in the exhibit below:
1.24 EXHIBIT-1: FOREX RATES & EXPOSURES
23-Oct-2001 0915 hrs
25-Oct-01
Currency Inter Spot 1 month 1 month 2 month 3 month

3 month 6 month 6 month LIBOR Prime
Bank TT buyTT Sell TT buyTT Sell % premia TT buyTT
Sell TT buyTT Sell % premia TT Buy TT Sell % premia
3 month 6 month Rate
U.S. Dollar 47.99 47.79 48.19 47.99 48.39

0.05 48.22 48.62 48.44 48.84
0.05 49.15 49.55 0.06 0.02 0.02 0.0675
Euro 0.89 42.26 43.33 42.41 43.49
0.04 42.58 43.66 42.76 43.84 0.05
43.32 44.41 0.05 0.04 0.03 0.0625
Deutsche Mark 2.19 21.61 22.16 21.69
22.24 0.04 21.77 22.32 21.86 22.42
0.05 22.15 22.71 0.05 0.04 0.03 0.08
Jap. Yen (100) 122.52 38.78 39.55 39.07 39.85
0.09 39.36 40.15 39.66 40.45
0.09 40.58 41.39 0.09 0.00 0.00
0.01375
Swiss Franc 1.66 28.73 29.45 28.87 29.39
0.02 29.01 29.54 29.16 29.69
0.05 29.63 30.16 0.06 0.02 0.02 0.0525
Pound Sterling 1.43 67.74 69.03 67.96
69.25 0.04 68.21 69.50 68.45 69.75
0.04 69.22 70.53 0.04 0.04 0.04 0.05
Belgian Franc 45.23 1.05 1.07 1.05 1.08
0.04 1.06 1.08 1.06 1.09
0.05 1.07 1.10 0.05 0.04 0.03 0.075
French Franc 7.36 6.44 6.61 6.47 6.63
0.04 6.49 6.66 6.52 6.68
0.05 6.60 6.77 0.05 0.04 0.03 0.071
Italian Lira (100) 2,171.19 2.18 2.24 2.19
2.25 0.04 2.20 2.25 2.21 2.26
0.05 2.24 2.29 0.05 0.04 0.03 0.0675
Dutch Guilder 2.47 19.18 19.66 19.25 19.74
0.04 19.32 19.81 19.40 19.89
0.05 19.66 20.15 0.05 0.04 0.03 0.0625
Canadian Dollar 1.58 30.13 30.65 30.24
30.77 0.05 30.37 30.90 30.50 31.02
0.05 30.91 31.44 0.05 0.03 0.03 0.06
Austrian Schilling 15.43 3.07 3.15 3.08
3.16 0.04 3.09 3.17 3.11 3.19
0.05 3.15 3.23 0.05 0.04 0.03
Danish Kroner 8.34 5.70 5.81 5.72 5.83
0.04 5.74 5.85 5.76 5.87
0.04 5.83 5.94 0.05 0.04 0.04
Singapore Dollar 1.83 26.06 26.48 26.20
26.63 0.06 26.36 26.78 26.51 26.93
0.07 26.98 27.41 0.07 0.02 0.02 0.05
Swedish Kroner 10.67 4.46 4.54 4.47
4.55 0.04 4.49 4.57 4.51 4.59
0.05 4.57 4.65 0.05 0.04 0.04
Australian dollar 0.51 24.13 24.81 24.20
24.89 0.04 24.29 24.97 24.37 25.06
0.04 24.64 25.33 0.04 0.04 0.04 0.0795
1.25 MATURITY MISMATCH OR GAPS
By using the above criteria, the Corporate Treasurer defines the gaps of the Company in
USD/INR and the crosses. A gap reflects a mismatch between the maturity dates and
inflows and outflows thereby creating an interest rate differential risk. For e.g., an import
payment for USD 100,000 may be due on the 1st of the month and an export payment for
the same amount would be receivable of the 15th of the same month. In this case, though
the company does not have any net foreign exchange position, it has a maturity
mismatch.
This gap can be closed out by doing a “Swap” where the Institution buys USD 100,000
for value 1st and sells USD 100,000 for the value 15th through the money market or
through Foreign Exchange forward markets.
We shall see now how the exposures are reported to the General Manager Finance in case
of exports and imports.
Exhibit No.2 represents the reporting system of exports. When a confirmed export order
is received the same is entered in Exhibit No.2 and the relevant data is completed from
information available from the export order.
Like wise when an import order is issued in favour of some supplier, the same is entered
in Exhibit No.3. The specimen of these formats is listed below. Exhibit 2 & 3 are sorted
on due dates to find out Maturity Mismatches or Gaps and the same are covered
separately.
FOREX EXPOSURE
EXHIBIT- 2: EXPORT OPEN ORDER-(AS ON DD\MM\YY)
PYMNT TYPE PO NOPO DATE SHIPMENT BANK STATUS FC

C/X FC AMT BUG SET BUDGTD BUDGTD ACTUAL
ACTUAL PERFORMANCE
TERM DATE RATE
AMT RATE AMT
21 B 1211 20.12.98 21.02.99 BNP EX/1111 USD C
44140 21.03.99 36.24 1599633.60 36.05 1591247.00 -8386.60
21 B 1212 21.12.98 22.02.99 BNP EX/1112 USD X
63750 21.03.99 36.46 2324325.00 35.93 2290537.50 -33787.50
21 B 1213 22.12.98 23.02.99 BNP EX/1113 USD X
43183 21.03.99 36.22 1564088.26 35.79 1545519.57 -18568.69
21 B 1214 23.12.98 24.02.99 BNP EX/1114 USD C
42000 21.03.99 36.92 1550640.00 36.62 1538040.00 -12600.00
21 B 1215 24.12.98 25.02.99 BNP EX/1115 USD C
84000 21.03.99 37.14 3119760.00 36.85 3095400.00 -24360.00
EXHIBIT-3 : IMPORT OPEN ORDER(AS ON DD\MM\YY)
PYMT TYPE PO NOPO DATE SHIPMENT BANK STATUS FC

C/X FC AMT BUG SET BUDGTD BUDGTD ACTUAL
ACTUAL PERFORMANCE
TERM DATE RATE
AMT RATE AMT
21 B I-1211 20.12.98 21.02.99 BNP DR/UR CHF X

24780 21.03.99 22.33 553337.40 36.05 893319.00 339981.60
60 B I-1212 21.12.98 22.02.99 BNP DR/UR CHF X
1650000 21.03.99 26.32 43428000.00 35.93 59284500.00
15856500.00
90 B I-1213 22.12.98 23.02.99 ANZ DR/UR CHF H
154503 21.03.99 26.49 4092784.47 35.79 5529662.37
1436877.90
90 B I-1214 23.12.98 24.02.99 ANZ DR/UR CHF H
3040 21.03.99 27.65 84056.00 36.62 111324.80 27268.80
90 B I-1215 24.12.98 25.02.99 ANZ DR/UR CHF X
11895 21.03.99 27.71 329610.45 36.85 438330.75 108720.30
NOTE:
Pymnt terms: Payment term of the order

Type: B-Basle, O-Others, G-group Companies
PO No: Purchase Order No
PO Date: Purchase Order Number
PO Recd: Date of which the order reaches the Treasury
Shipment: Shipment Date
Bank: Thru which Order was settled
Status: DR-document received, UR-under retirement
FC: Foreign Currency
C/X: C-covered, E-Exposed, H-Hedged
FC: Invoice in Foreign Currency Amt
BUD SETT DT: Forecasted Settlement Sate
BUD RATE: The forward rate for that duration as quoted in the PO recd date
BUD AMT: (FC Amt X Budgeted Rate)
ACUTAL RATE: Actual Rate
ACUTAL AMT: (FC Amt X Actual Rate)
PERFORMANCE : Difference between Budgeted & Actual
STRUCTURE OF LIMITS
The Foreign Exchange Policy should clearly outline the limits of all foreign exchange
positions and gaps of the country. These limits on risk taking must be decided bearing in
mind the risk profile of the company and the quantum of capital the company is willing to
put a risk on account of movements of exchange rates. The foreign exchange policy as
approved by the Board of Directors should define the following limits:
1.26 Overall Limits
1. Total open position limit for the company either as a percentage of net position or
as a fixed limit based on capital adequacy.
2. Total open gap position limit for the Company.

The policy should not only define the personnel authorised to engage in foreign exchange
business but also outline who will be authorised to deal in what type of foreign exchange
products .
For example the dealers may only be allowed to engage in outright purchases or sales of
foreign exchange but all foreign exchange option transactions are done by the Corporate
Treasurer and Interest Rate or Currency Swaps may be done subject to senior
management approval.
The overall limits in the case of M/s Ciba Specialty Chemicals India Limited are fixed at
80% to 120% of total exposure. The Direct Hedge PLUS Internal Hedge should at no
point of time of time exceed 120% of total exposure.
Hence a cascading structure of limits for all type of foreign exchange products is to be
outlined for:
• Senior Management (Managing Director/Vice President)
• Corporate Treasurer
• Dealers
1.27 Individual Dealer Limits
• Type of foreign exchange products that can be dealt.
• Position and gap limit of each authorised dealer. Each dealer can have a different
limit based on his experience and expertise.
• Deal size limit. Each dealer should have a limit on the size of any individual deal.
Different dealers may have different deal size limits.
The policy also defines the hierarchy for approval of temporary increases/changes in
limits. The Board of Directors approves an Increase in the total open position or open gap
position of the company. Similarly, the policy also outlines the reporting and approval
hierarchy for all types of limit excesses by the dealers or Corporate Treasurer based on
the quantum of excess.
GUIDELINES FOR RISK MANAGEMENT
One of the following strategies may be adopted for the management of currency
exposures:
1.28 HEDGING
The company may cover all exposures for forward maturities as they arise, i.e. when
import orders are placed or export orders are received or foreign currency loans are
availed of. The company should as far as possible match offsetting exposures prior to
taking cover. However, when the company matches offsetting exposures, this may result
in a gap or a maturity mismatch. Hence the company would need to close out these gaps
by doing Swaps.
The company may also follow a policy of keeping a certain pre-defined percentage of
their exposures covered. For example, the company may cover only 50% of net import
exposures in USD/INR, whereas net USD/FCY could continue to be covered 100%. This
strategy could, in some circumstances, save the company the cost of USD/INR discounts.
CSCIL has its import exposures in CHF and export exposures in USD. However, in
imports, it covers only USD / Rest and covers CHF/USD either subsequently or on spot
depending on circumstances/market rates.
1.29 PASSIVE RISK MANAGEMENT
The company can choose to cover selectively and progressively based on its view of
individual currency movements. Hence, the company may leave some portions of their
foreign exchange exposure or gaps open with the aim of capitalising on certain
anticipated market movements.
However, the company could stand to lose should the market not move in the anticipated
direction. This would result in increased cost of imports or lower realisation of exports. In
order that this negative effect is contained the company should define “Stop-Loss” limits
for all open positions. The stop-loss limit should be defined based on the quantum of
money the company is willing to risk on its open position. Conversely, “Take-Profit”
limits should also be defined to enable the company to crystallise gains on profitable
open positions.
Secondly, the company should decide the extent of total foreign exchange exposures and
gaps that the Central Treasury may keep open either as a percentage of its total exposure,
or as a fixed limit, for e.g., USD 5 million.
CSCIL has not yet defined its “stop-loss” or “take-profit” limits and its policy is purely
based on the overall limits. However in the long run it proposes to fix such limits on the
budgeted rate on the day the exposure arises.
1.30 ACTIVE RISK MANAGEMENT
In addition to the above mentioned risk management strategies, the company may also
decide to trade in the currencies in which it has underlying exposures and hence an
existing need to manage exchange risk. This activity should then be viewed as an
additional product line or profit center.
However, this activity should be carried out after adequate internal approval (Board –
approved). Risk Management Policy is obtained and with an appropriate degree of
internal control. This includes:
• Persons authorised to create risk positions and the spot position limit and gap
limit of each trader so authorised.
• Stop-Loss Limits for all open positions, either as a percentage variance of the
exchange rate, or as a quantum of money at risk per trader per day/month.
• Total open position limits and gap limits for the company at any given point in
time, or total money at risk limit across these activities.
It should also be noted that, due to Exchange Control restrictions “Active Risk
Management” is curtailed to the extent possible within documentation constraints and
against underlying open exposure.
The objective of the Corporate Treasurer is managing forex exposure and minimising
losses due to fluctuations at CSCIL. Even though realised Gains/Losses are accounted as
a separate profit center the objective is not profit making, but to cover risks. Therefore,
CSCIL is in no way in favor of Active Risk Management.
VALUATIONS OF FOREIGN EXCHANGE EXPOSURES
The company makes an analysis of the performance of its foreign exchange portfolio in
order to value at current market rates the cost of its imports, exports, loans, etc., and thus
measure the impact of exchange/interest movements on its Balance Sheet and Profit &
Loss Account on a monthly basis.
In order to achieve this, the company also assigns a budget rate or target rate to its
exposures as and when they arise. This rate can be the forward value of the exposure on
the day the exposure is recognised, which is calculated by adding the premium amount to
the spot value of that currency.
The performance or the portfolio is then to be measured against these budgeted rates by
comparing the market rates prevailing at which the exposure can be covered against the
budgeted rate.
In the case of passive & active risk management, there may be trading positions where
the budgeted rate would be the rate at which the position was initiated as this would also
be valued at prevailing market rates (also known as Market-to-Market).
Accounting for the effects of changes in foreign exchange rates may be done in
accordance with the Accounting Standards 11(revised) issued by the Institute of
Chartered Accountants of India.
Exchange Gains or Losses at M/s CSCIL are classified under the following account
heads:
1. Realised Gains/Losses - Inter Company

2. Realised Gains/Losses - Third Party
3. Realised Gains/Losses - Forward Covers
4. Realised Gains/Losses - Cancellations
INTERNAL CONTROLS
The Institution needs to monitor open positions and stop loss limits on a continuous basis
and evaluate periodically the performance of the foreign exchange portfolio.
The Central Treasury reports, on a weekly basis, the open positions and open gaps to
Senior Management as represented in Exhibit 1 . This is counter checked by an
Independent Settlements Departments. The Settlements Department monitors positions of
the dealers and any excesses of any limits are to be reported directly to the senior
management.
The foreign exchange portfolio is marked to market at least once a week and a valuation
report (cross checked by Settlements) is sent by the Corporate Treasurer to Management .
The Board of Directors also reviews the portfolio performance periodically.
Internal Audits addresses the functioning of the Central Treasury, adherence to policy &
operational risks.
ORGANOGRAM of M/s Ciba Specialty Chemicals India Limited
1.31 BALANCE OF PAYMENT

1.31.1 SOME BASIC CONCEPTS
The fundamental reason why foreign trade benefits an economy is the so-called
principle of comparative advantage. If different countries concentrate on providing
products and services in which they have comparative advantages arising out of
differences in resources, costs or technology, then international trade can be beneficial to
all the countries. Remember, we are referring to relative, and not absolute, efficiency of
producing goods and services’ in other words, even if a country is the most efficient
producer of all the goods and services it needs it will still benefit by engaging in
international trade, as the relative efficiencies would surely differ in practice.
1. Balance of Payments of a country is systematic records of all receipts and payments

between residents of the country with non-residents of the country over a period of time,
say one year. These receipts and payments could be of account on account of import and
export of goods and the difference on this account is known as ‘balance of trade.’
2. If receipt and payments on account of import and export of services like tourism,
banking, insurance etc are also added to that of goods then the difference on this account
is known as ‘balance on current account.’
3.The 3rd component of balance of payment is grants, aids, foreign investment etc falls
under Capital Account.
Thus, receipt and payments on account of all the three components make the “Balance of
Payments” of the country.
Incidentally the BOP of a country is always balanced. If the receipt under the 3
components i., e goods, services and capital account are less than the payments then the
BOP of the country is said to be negative or adverse. Since BOP is always balanced the
balancing is done thru Foreign Exchange Reserve of the country.
The principle of comparative advantage is easy to understand. The classic textbook

example is that of a person who happens to be both the best lawyer as well as the best
stenographer in the city.
Let us assume that as a lawyer he can earn Rest. 5000/- Per Hour while he can hire a
stenographer[who may not be as good as himself] at say Rest. 50/- Per Hour. It obviously
makes economic sense for the lawyer to hire a stenographer and devote all his time to
working as a lawyer as his comparative advantage, given the earnings and expenses,
obviously lies in working as a lawyer. It is a known factor that international trade benefits
an economy, the question of external receipts and payments has to be considered. It is
customary to classify a country’s external receipts and payments under two broad
headings- Current Account and Capital Account. The third category falling under BOP is
the Reserve Account.
1.32 Components of Balance Of Payments:
1.32.1 Current account
The Current Account in turn, is split under two heads -
1. Trade flows &

2. Invisibles
Of the two trade flows comprising exports and imports of goods is easier to understand.
The difference between the two is commonly referred to as the surplus or deficit trade
balance. It is customary to report imports on CIF basis and exports on FOB basis for
calculating the trade balance.
1.32.2 Trade flows
Strong economic growth of economy in 1995-96 resulted in widening of the trade deficit
to USD 8.9 bn. However, high interest rates and an overall liquidity squeeze in the
corporate sector through second half of 1996 saw growth taper off rapidly. This was
reflected in non-pol [petroleum, oil, lubricants] imports decline by 4 percent during April
November 1996 as against an increase of 36 percent last year’s, whereas imports till
November were up by 4.66 percent, exports showed slightly higher growth at 7.81
percent, resulting in narrowing of the trade deficit. It is expected that the trade for 1996-
97 would be between 7.5 to 8 bn. Conventionally, trade in physical goods is distinguished
from trade-in services. Invisibles comprise current international payments for items other
than merchandise exports or imports. Some of the more important items under the head
[invisibles] comprising travel, transportation and insurance, interest, indenting
commission, export commissions, research income, dividend payments and other
miscellaneous income and expenditure.
1.32.3 Invisibles
Invisibles have maintained a rising trend in recent years, on account of steady increase in
private transfer receipts. It is expected that this trend would continue as a moderate rate
at the rate of [20] percent in 1996-97. Trade flows and invisibles together comprise the
current account of a country and the difference give the current account surplus deficit.
1.32.4 Deficit & Surplus
Meaning of Deficit and Surplus in BOP
1. BOP is a double entry accounting record and hence must balance except for errors
and omissions.
2. As such deficit or surplus refer to subsets of accounts included in BOP. These are
imbalances or economic disequilibria.
3. Need to optimally group various accounts within BOP statement so as to give

proper signals to the authorities to correct disequilibrium.
4. Division of entire BOP into set of accounts

a. Above the line (if the net balance is positive, then there is BOP surplus and if
negative, there is a BOP deficit).
b. Below the line (this net balance should be equal in magnitude but opposite in sign
of the balance above the line).
5. The items below the line are "compensatory" in nature. They "finance or settle"
the imbalance above the line.
6. The transactions above the line are "autonomous transactions". This means a
transaction undertaken for its own sake, in response to given configuration of price,
exchange rate, interest rate, etc. and usually to realize profit / reduce cost. It does not
take into account situation elsewhere in the BOP.
7. An accommodating transaction (below the line) is undertaken with a view to settle

the imbalance arising out of other transactions. For e.g. financing the deficits arising out
of autonomous transactions.
8. BOP deficit or surplus is understood to mean deficit or surplus on all autonomous

transactions taken together.
Difficulties in deciding what is autonomous and what is accommodating.
9. Exports and imports of goods / services, private sector capital flows, migrant
workers remittances, unilateral gift are all clear cases of autonomous transactions.
10. Sale or purchase of foreign exchange to engineer certain movements in exchange

rate is clearly an accommodating transaction.
11. Government borrowing from World Bank may be used to finance the deficit on
other transactions or to finance a public sector project or a combination. In the first case,
it is an accommodating transaction in the second case an autonomous while in the third, it
is a mixture.
12. Some degree of ambiguity is inevitable. As such, several concepts of "balance "
have evolved:
• Trade Balance: This is the balance on the merchandise trade account.

• Balance on goods and services: This is the balance between exports and imports
of goods and services (in the current account, excludes private transfers and investment
income).
• Current Account Balance: This is the net balance on the entire current account.
• Balance on current account and long-term capital (also known as basic balance):
Indicates long-term trends in the BOP. The idea is short term capital flows are volatile
but long term capital flows are of a more permanent nature and are indicative of the under
laying strengths and weaknesses of the economy.
13. Errors and omissions

While changes in reserve assets are accurately measured and recorded, some other
items are subject to errors arising out of data inadequacy, errors in reporting, discrepancy
in valuation and timing. These are group together under this heading.
Relevance of BOP Statistics and Decision Making

14. Impact on the exchange rates in the short term. BOP reflects excess demand over
supply or otherwise for the currency.
15. Data for successive months can give an indication of trends - their accentuation or
reversal.
16. Signal of policy shift by the monetary authorities either unilaterally or with the
trading partners.
17. A country facing current account deficit may resort to raise interest rates to attract
short-term capital inflows to arrest depreciation of the currency.
18. Continuing current account deficit may lead to tax incentives.
19. Who bears exchange risk?

a. If invoice is in exporter's currency, the importer bears the risk and vice versa.
b. More often, US Dollar, both bear the risk.
c. Currency risk hedging possible with forward markets
1.32.5 Capital Account
Transfers on capital account include external borrowings or payments of external

borrowings, external investments or disinvestments. The balance of current account and
capital account together will result in the country’s reserves of foreign exchange going up
or down correspondingly.
A current account deficit may be combined with a higher capital account surplus and
therefore reflect as an addition to the country’s reserves of foreign exchange.
The current account deficit or surplus of a country can also be looked at in another way.
In macro economic and national accounting term the current account is a mirror image of
the difference between domestic savings and domestic investments. If domestic savings
exceed the domestic investments then a surplus on current account will result. On the
other hand if the domestic savings are insufficient to finance the domestic investments a
deficit on current account would result and would need to be financed either through a
draw down of reserves or by external borrowings.
The Management of Foreign Exchange Risk

1.33 OVERVIEW
(a) Goals
Exchange risk is the effect that unanticipated exchange rate changes have on the value of
the firm. This chapter explores the impact of currency fluctuations on cash flows, on
assets and liabilities, and on the real business of the firm. Three questions must be asked.
First, what exchange risk does the firm face, and what methods are available to measure
currency exposure?
Second, based on the nature of the exposure and the firm's ability to forecast currencies,
what hedging or exchange risk management strategy should the firm employ?
And finally, which of the various tools and techniques of the foreign exchange market
should be employed: debt and assets; forwards and futures; and options. The chapter
concludes by suggesting a framework that can be used to match the instrument to the
problem.
(b) What is exchange risk?
Exchange risk is simple in concept: a potential gain or loss that occurs as a result of an
exchange rate change.
For example, if an individual owns a share in Hitachi, the Japanese company, he or she
will lose if the value of the yen drops.
Yet from this simple question several more arise. First, whose gain or loss? Clearly not
just those of a subsidiary, for they may be offset by positions taken elsewhere in the firm.
And not just gains or losses on current transactions, for the firm's value consists of
anticipated future cash flows as well as currently contracted ones. What counts, modern
finance tells us, is shareholder value; yet the impact of any given currency change on
shareholder value is difficult to assess, so proxies have to be used. The academic
evidence linking exchange rate changes to stock prices is weak.
Moreover the shareholder who has a diversified portfolio may find that the negative
effect of exchange rate changes on one firm is offset by gains in other firms; in other
words, that exchange risk is diversifiable. If it is, than perhaps it's a non-risk.
Finally, risk is not risk if it is anticipated. In most currencies there are futures or forward
exchange contracts whose prices give firms an indication of where the market expects
currencies to go. And these contracts offer the ability to lock in the anticipated change.
So perhaps a better concept of exchange risk is unanticipated exchange rate changes.
These and other issues justify a closer look at this area of international financial
management.
1.34 SHOULD FIRMS MANAGE FOREIGN EXCHANGE RISK-HOW?

Many firms refrain from active management of their foreign exchange exposure, even
though they understand that exchange rate fluctuations can affect their earnings and
value. They make this decision for a number of reasons.
First, management does not understand it. They consider any use of risk management
tools, such as forwards, futures and options, as speculative. Or they argue that such
financial manipulations lie outside the firm's field of expertise. Saying like "we are in the
business of manufacturing slot machines, and we should not be gambling on currencies."
Perhaps they are right to fear abuses of hedging techniques, but refusing to use forwards
and other instruments may expose the firm to substantial speculative risks.
Second, they claim that exposure cannot be measured. They are right-currency exposure
is complex and can seldom be gauged with precision. But as in many business situations,
imprecision should not be taken as an excuse for indecision.
Third, they say that the firm is hedged. All transactions such as imports or exports are
covered, and foreign subsidiaries finance in local currencies. This ignores the fact that the
bulk of the firm's value comes from transactions not yet completed, so that transactions
hedging is a very incomplete strategy.
Fourth, they say that the firm does not have any exchange risk because it does all its
business in dollars (or yen, or whatever the home currency is). But a moment's thought
will make it evident that even if you invoice Japanese customers in dollars, when the Yen
drops your prices will have to adjust or you'll be undercut by local competitors. So
revenues are influenced by currency changes.
Finally, they assert that the balance sheet is hedged on an accounting basis-especially
when the "functional currency" is held to be the dollar.
But is there any economic justification for a "do nothing" strategy?
Modern principles of the theory of finance suggest prima facie that the management of
corporate foreign exchange exposure may neither be an important nor a legitimate
concern.
It has been argued, in the tradition of the Modigliani-Miller Theorem, that
the firm cannot improve shareholder value by financial manipulations: specifically,
investors themselves can hedge corporate exchange exposure by taking out forward
contracts in accordance with their ownership in a firm. Managers do not serve them by
second-guessing what risks shareholders want to hedge.
One counter-argument is that transaction costs are typically greater for individual
investors than firms. Yet there are deeper reasons why foreign exchange risk should be
managed at the firm level. The assessment of exposure to exchange rate fluctuations
requires detailed estimates of the susceptibility of net cash flows to unexpected exchange
rate changes. Operating managers can make such estimates with much more precision
than shareholders who typically lack the detailed knowledge of competition, markets, and
the relevant technologies. Furthermore, in all but the most perfect financial markets, the
firm has considerable advantages over investors in obtaining relatively inexpensive debt
at home and abroad, taking maximum advantage of interest subsidies and minimizing the
effect of taxes and political risk.
Another line of reasoning suggests that foreign exchange risk management does not
matter because of certain equilibrium conditions in international markets for both
financial and real assets. These conditions include the relationship between prices of
goods in different markets, better known as Purchasing Power Parity (PPP), and between
interest rates and exchange rates, usually referred to as the International Fisher Effect.
However, deviations from PPP and IFE can persist for considerable periods of time,
especially at the level of the individual firm. The resulting variability of net cash flow is
of significance as it can subject the firm to the costs of financial distress, or even default.
Modern research in finance supports the reasoning that earnings fluctuations that threaten
the firm's continued viability absorb management and creditors' time, entail out-of-pocket
costs such as legal fees, and create a variety of operating and investment problems,
including under investment in R&D. The same argument supports the importance of
corporate exchange risk management against the claim that in equity markets it is only
systematic risk that matters.
To the extent that foreign exchange risk represents unsystematic risk, it can, of course, be
diversified away provided again, that investors have the same quality of information
about the firm as management-a condition not likely to prevail in practice.
This reasoning is buttressed by the likely effect that exchange risk has on taxes paid by
the firm. It is generally agreed that leverage shields the firm from taxes, because interest
is tax deductible whereas dividends are not. But the extent to which a firm can increase
leverage is limited by the risk and costs of bankruptcy.
A riskier firm, perhaps one that does not hedge exchange risk, cannot borrow as much. It
follows that anything that reduces the probability of bankruptcy allows the firm to take on
greater leverage, and so pay less taxes for a given operating cash flow. If foreign
exchange hedging reduces taxes, shareholders benefit from hedging.
However, there is one task that the firm cannot perform for shareholders: to the extent
that individuals face unique exchange risk as a result of their different expenditure
patterns, they must themselves devise appropriate hedging strategies. Corporate
management of foreign exchange risk in the traditional sense is only able to protect
expected nominal returns in the reference currency.
1.35 Economic Exposure, Purchasing Power Parity & The International Fisher Effect
Exchange rates, interest rates and inflation rates are linked to one another through a
classical set of relationships, which have import for the nature of corporate foreign
exchange, risk. These relationships are:
(1) the Purchasing Power Parity Theory, which describes the linkage between relative
inflation rates and exchange rates;
(2) the International Fisher effect, which ties interest rate differences to exchange rate
expectations; &
(3) the unbiased forward rate theory, which relates the forward
exchange_rate-to-exchange_rate expectations. These relationships, along with two other
key "parity" linkages.
1.36 Foreign Exchange Forecasting
Forecasting foreign exchange rate is important for forex management as it reduces the
uncertainties associated with commitments to accept or to make payments in foreign
currencies with short-term and long-term investment decisions, with financing decisions
and with income earned in foreign currencies. It is also important for a forex manager to
understand the intricacies and the limitations of forecasting foreign exchange rates as it
helps them to utilize the alternate avenues to manage exchange rate risk. Though it is
difficult to forecast the exact time of change or change on a particular day, the available
forecasts are accurate enough to forecast direction and magnitude of change in longer
term.
Hence, exchange rate forecast are very useful in planning long-term investments. The
exchange rate forecasts help to:
1. Analyze attractiveness of foreign borrowings

2. Plan investments in foreign countries
3. Plan long term export-import strategy
4. Manage exchange rate risks and plan hedging strategies
1.37 Historical perspective on exchange rate, Gold standard
• Exchange Rate : Is the value of one currency in terms of another.

• Exchange Rate Regime : Refers to mechanism, procedure and institutional
framework for determining exchange rates at a point of time and changes in the same
over a period of time including the factors, which induce the changes.
• Two extremes of exchange rate regimes
1. Perfectly rigid or fixed exchange rates.
2. Perfectly flexible or floating.
3. Between the two extremes, a number of hybrids with varying degrees of
flexibility.
1.37.1 Gold standard
• Oldest system till world war 1
• Gold specie standard : Actual currency in circulation consisted of gold coins with
fixed gold content.
• Gold bullions standard : The basis of money remains a fixed rate of gold.
Currency is paper and authorities standing ready to convert unlimited amount of paper
currency into gold and vice versa at fixed conversion ratio.
• Gold exchange standard : Authorities standing ready to convert, at a fixed rate,

the paper currency issued by them into another paper currency of different country
operating on gold specie or gold bullion standard.
• Monetary authorities must obey three golden rules
1. They must fix rate of conversion of paper money issued by them into gold.
2. They must ensure free flow of gold between countries on gold standard.
3. Money supply in country must be tied to the amount of gold held by monetary
authorities in reserve.
• Pros and cons of gold standard regimes
1. Stable and predictable exchange rates

2. Built in anti-inflationary bias – no reckless expansion of money supply
3. Imposes very rigid discipline
4. Politically difficult to administer
5. Limping gold standard
6. If authorities suspend the free convertibility of paper currency into gold, it is
called limping gold standard.
7. Britain restored gold standard at end of world war-I but finally abandoned in
1931, when faced with prospect of massive gold outflow
Interwar instability and Bretton Woods, Change over from fixed exchange rates to
fluctuating exchange rates.
1.37.2 Definition of Arbitrage
A transaction in which one buys something for a given sum of money and after going
through one or more buy / sell transactions, ends up with a larger sum of money than
what was spent at the beginning, thus realizing an arbitrage profit without exposure to
any risk.
Interwar period :
• Break down of gold standard.
• Stock market crash in late 20’s pushing USA into recession.
• Fall in imports by USA and consequent trade deficits by European countries,
which had to be financed by export of gold.
• Fall in domestic money supply and hence deflation.
• Fall in currency values and finally UK decides to quit gold standard. 25 other
countries follow suit.
1.37.3 Bretton Wood’s System
• 1944: Near end of Word War II, allied powers, UK and USA took up the task of
thorough overall of international monetary system.
• Exchange rate regime put in place can be characterized as gold exchange standard
(in 1968 it became limping gold exchange standard).
• Birth of International Monetary Fund (IMF) and World Bank
1.38 Features of Exchange Rate System
• US Government commitment to convert dollars freely into gold at US dollars 35

per Oz.
• Other members countries of IMF agreed to fix the parities of their currencies vis-
à-vis the dollar with variation within 1% on either side of central permissible parity.
• Should the exchange rate hit either of the limits, monetary authorities of the
country obliged to “defend” its own currency through buy / sell of dollars to any extent
required to keep the exchange rate within the limits.
• Member countries of IMF allowed to borrow from IMF to carry out interventions.
• Thus, Bretton Woods introduced “adjustable” rate system in place of “fixed rate
(equal to gold standard)” system.
• Parity of currency against the dollar could be changed in case of “fundamental

disequilibrium”.
• Fundamental disequilibrium : when at a given exchange rate, the country

repeatedly faces BOP disequilibrium and has to constantly intervene and either buy or
sell dollars.
• Changes up to +/- 10 % could be made without the consent of IMF while larger
changes with IMF’s approval.
• US Government undertook obligation not to change value of dollar.
1.38.1 Collapse of Bretton Woods System (1944 to 1971)
• Triffin Paradox : Bretton Woods System depended on dollar performing its role as
key currency. Countries other than US had to accumulate dollars to make payments.
Hence, US had to run BOP deficits.
• 1944 to 1960 US deficits were moderate. War ravaged Europe and Japan
economies were being rebuilt.
• 1960s saw rising BOP deficits of USA. Result : Loss of faith in ability of the US
to convert dollars into gold.
• US gold stock inadequate to honor convertibility commitments.
• Abortive attempt to salvage the system by means of series of parity realignments
dollar devaluation in terms of gold and widening bands around central parities.
• US finally abdicated its role as anchor of world monetary system and era of
floating exchange rates starts.
1.39 Floating Exchange Rate System
• Original proponent was Milton Friedman (1953).

• Relative price of currency determined by demand and supply and authorities
make no attempt to hold exchange rate.
• In freely floating exchange rate situation, no effort is made by the authorities to
influence current value and future evolution of exchange rate. This is theoretical.
• In practice interventions (managed or dirty floats) so as to smoothen out short
terms fluctuations or force the rate towards a particular target value.
1.40 Objectives of Limited Flexibility System
• To introduce flexibility into fixed rate system.

• To effect changes in gradual and plant banner rather than abrupt or unpredictable
manner (seen in floating rate system).
1.41 Crawling peg (gliding parities)
• Replaces the abrupt parity changes with gradual modification with permissible
variations around parity in a narrow band (usually) +/-1 %.
• Change in parity in a year is subject to sub ceiling say not more than 8.33% of
variation per month.
• Parity changes carried out based on set of indicators like current account deficit,
relative inflation rates and moving average of past spot rates.
• Brazil and Portugal have adopted in past.
1.42 Mixed System

• Some transactions are subject to fixed rate while others are subject to market
determined floating rates.
• Belgium (1955 to 1990) operated current account transactions at fixed rate and
capital flows at floating rate.
• Motive is to control capital flows.
• Commercial market meant for current account transactions allowed to be operated
by “authorized dealers”.
• Financial market meant for capital transactions open to all participants.
1.43 Exchange Rate Arrangements
• Exchange rate of any currency settled in many ways:
1. Administered by Central Bank

2. Market forces
3. Combinations between the two exchanges
• IMF classifies exchange arrangements under 3 heads
1. Pegged to a single currency (dollar or Euro) or currency basket like SDR.

2. Flexibility limited against single currency (Danish Krone against Euro).
3. Managed or independently floating.
1.44 Market Size
1. Daily Foreign Exchange Transaction Volume > US $2 trillion.

2. World Merchandised Exports in 1997 = US $ 5.3 trillion.
3. World Trade of Services (1997) = US $ 1.3 trillion.
4. Conclusion : Over 90% transactions are financial or speculative.
5. With introduction of Euro, intra-European trading will die.
6. Trade with emerging markets will boom. East Asia melt down is expected to be
temporary phase and on the whole this trade will compensate for loss of intra-European
trade.
7. US dollars remains most traded currency in market and involved in 87% of world
transactions.
8. Geographical spread from Tokyo to West Coast of USA.
1.45 Mechanics Of Exchange Rate
The Purchasing Power Parity (PPP) theory can be stated in different ways, but the most
common representation links the changes in exchange rates to those in relative price
indices in two countries.
Rate of change of exchange rate = Difference in inflation rates
The relationship is derived from the basic idea that, in the absence of trade restrictions
changes in the exchange rate mirror changes in the relative price levels in the two
countries. At the same time, under conditions of free trade, prices of similar commodities
cannot differ between two countries, because arbitragers will take advantage of such
situations until price differences are eliminated. This "Law of One Price" leads logically
to the idea that what is true of one commodity should be true of the economy as a whole--
the price level in two countries should be linked through the exchange rate--and hence to
the notion that exchange rate changes are tied to inflation rate differences.
The International Fisher Effect (IFE) states that the interest rate differential will exist
only if the exchange rate is expected to change in such a way that the advantage of the
higher interest rate is offset by the loss on the foreign exchange transactions.
This International Fisher Effect can be written as follows:
The expected rate of change of the exchange rate = The interest rate differential
In practical terms the IFE implies that while an investor in a low-interest country can
convert his funds into the currency of the high-interest country and get paid a higher rate,
his gain (the interest rate differential) will be offset by his expected loss because of
foreign exchange rate changes.
The Unbiased Forward Rate Theory asserts that the forward exchange rate is the best, and
an unbiased, estimate of the expected future spot exchange rate. The theory is grounded
in the efficient markets theory, and is widely assumed and widely disputed as a precise
explanation.
The "expected" rate is only an average but the theory of efficient markets tells us that it is
an unbiased expectation--that there is an equal probability of the actual rate being above
or below the expected value.
The unbiased forward rate theory can be stated simply:
The expected exchange rate = The forward exchange rate
Now, we can summarize the impact of unexpected exchange rate changes on the
internationally involved firm by drawing on these parity conditions. Given sufficient
time, competitive forces and arbitrage will neutralize the impact of exchange rate changes
on the returns to assets; due to the relationship between rates of devaluation and inflation
differentials, these factors will also neutralize the impact of the changes on the value of
the firm .
This is simply the principle of Purchasing Power Parity and the Law of One Price
operating at the level of the firm. On the liability side, the cost of debt tends to adjust as
debt is repriced at the end of the contractual period, reflecting (revised) expected
exchange rate changes. And returns on equity will also reflect required rates of return; in
a competitive market these will be influenced by expected exchange rate changes.
Finally, the unbiased forward rate theory suggests that locking in the forward exchange
rate offers the same expected return as remaining exposed to the ups and downs of the
currency -- on average, it can be expected to err as much above as below the forward rate.
In the long run, it would seem that a firm operating in this setting will not experience net
exchange losses or gains. However, because of contractual, or, more importantly,
strategic commitments, these equilibrium conditions rarely hold in the short and medium
term.
Therefore, the essence of foreign exchange exposure, and, significantly, its management,
is made relevant by these "temporary deviations."
1.46 Identifying Exposure
The first step in management of corporate foreign exchange risk is to acknowledge that
such risk does exist and that managing it is in the interest of the firm and its shareholders.
The next step, however, is much more difficult: the identification of the nature and
magnitude of foreign exchange exposure. In other words, identifying what is at risk, and
in what way.
The focus here is on the exposure of non financial corporations, or rather the value of
their assets. This reminder is necessary because most commonly accepted notions of
foreign exchange risk hedging deal with assets, i.e., they are pertinent to (simple)
financial institutions where the bulk of the assets consists of (paper) assets that have with
contractually fixed returns, i.e., fixed income claims, not equities.
Clearly, such time your assets in the currency in which they are denominated" applies in
general to banks and similar firms.
Non-financial business firms, on the other hand, have, as a rule, only a relatively small
proportion of their total assets in the form of receivables and other financial claims. Their
core assets consist of inventories, equipment, special purpose buildings and other tangible
assets, often closely related to technological capabilities that give them earnings power
and thus value. Unfortunately, real assets (as compared to paper assets) are not labeled
with currency signs that make foreign exchange exposure analysis easy.
Most importantly, the location of an asset in a country is an all too fallible indicator of
their foreign exchange exposure.
The task of gauging the impact of exchange rate changes on an enterprise begins with
measuring its exposure, that is, the amount, or value, at risk. This issue has been clouded
by the fact that financial results for an enterprise tend to be compiled by methods based
on the principles of accrual accounting. Unfortunately, this approach yields data that
frequently differ from those relevant for business decision-making, namely future cash
flows and their associated risk profiles. As a result, considerable efforts are expended --
both by decision makers as well as students of exchange risk -- to reconcile the
differences between the point-in-time effects of exchange rate changes on an enterprise in
terms of accounting data, referred to as accounting or translation exposure, and the
ongoing cash flow effects which are referred to as economic exposure. Both concepts
have their grounding in the fundamental concept of transactions exposure.
The relationship between the three concepts is illustrated in the Exhibit 2. Some basic
concepts are mentioned here to make the present chapter self-contained.
(a) Exposure in a simple transaction
The typical illustration of transaction exposure involves an export or import contract

giving rise to a foreign currency receivable or payable. On the surface, when the
exchange rate changes, the value of this export or import transaction will be affected in
terms of the domestic currency.
However, when analyzed carefully, it becomes apparent that the exchange risk results
from a financial investment (the foreign currency receivable) or a foreign currency
liability (the loan from a supplier) that is purely incidental to the underlying exports or
import transaction; it could have arisen in and of itself through independent foreign
borrowing and lending. Thus, what are involved here are simply foreign currency assets
and liabilities, whose value is contractually fixed in nominal terms.
While this traditional analysis of transactions exposure is correct in a narrow, formal

sense, it is really relevant for financial institutions, only. With returns from financial
assets and liabilities being fixed in nominal terms, they can be shielded from losses
with relative ease through cash payments in advance (with appropriate discounts),
through the factoring of receivables, or via the use of forward exchange contracts, unless
unexpected exchange rate changes have a systematic effect on credit risk.
However, the essential assets of non financial firms have non contractual returns, i.e.
revenue and cost streams from the production and sale of their goods and services which
can respond to exchange rate changes in very different ways.
(b) Accounting Exposure
The concept of accounting exposure arises from the need to translate accounts that are
denominated in foreign currencies into the home currency of the reporting entity.
Most commonly the problem arises when an enterprise has foreign affiliates keeping
books in the respective local currency. For purposes of consolidation these accounts must
somehow be translated into the reporting currency of the parent company. In doing this, a
decision must be made as to the exchange rate that is to be used for the translation of the
various accounts. While income statements of foreign affiliates are typically translated at
a periodic average rate, balance sheets pose a more serious challenge.
To a certain extent this difficulty is revealed by the struggle of the accounting profession
to agree on appropriate translation rules and the treatment of the resulting gains and
losses. A comparative historical analysis of translation rules may best illustrate the issues
at hand.
1.47 Method Followed By US Companies
Over time, U.S. companies have followed essentially four types of translation methods.
These four methods differ with respect to the presumed impact of exchange rate changes
on the value of individual categories of assets and liabilities. Accordingly, each method
can be identified by the way in which it separates assets and liabilities into those that are
"exposed" and are, therefore, translated at the current rate, i.e., the rate prevailing on the
date of the balance sheet, and those whose value is deemed to remain unchanged, and
which are, therefore, translated at the historical rate.
Method 1. The current/non current method of translation divides assets and liabilities
into current and non-current categories, using maturity as the distinguishing criterion;
only the former are presumed to change in value when the local currency appreciates or
depreciates vis-à-vis the home currency.
Method 2. Supporting this method is the economic rationale that foreign exchange rates
are essentially fixed but subject to occasional adjustments that tend to correct themselves
in time. This assumption reflected reality to some extent.
However, with subsequent changes in the international financial environment, this
translation method has become outmoded; only in a few countries is it still being used.
Method 3. Under the monetary/non-monetary method all items explicitly defined in

terms of monetary units are translated at the current exchange rate, regardless of their
maturity. Non-monetary items in the balance sheet, such as tangible assets, are translated
at the historical exchange rate. The underlying assumption here is that the local currency
value of such assets increases (decreases) immediately after a devaluation (revaluation) to
a degree that compensates fully for the exchange rate change. This is equivalent of what
is known in economics as the Law of One Price, with instantaneous adjustment.
Method 4. A similar but more sophisticated translation approach supports the so-called
Temporal Method. Here, the exchange rate used to translate balance sheet items depends
on the valuation method used for a particular item in the balance sheet. Thus, if an item is
carried on the balance sheet of the affiliate at its current value, it is to be translated using
the current exchange rate.
Alternatively, items carried at historical cost are to be translated at the historical

exchange rate. As a result, this method synchronizes the time dimension of valuation with
the method of translation. As long as foreign affiliates compile balance sheets under
traditional historical cost principles, the temporal method gives essentially the same
results as the monetary/non-monetary method. However, when "current value
accounting" is used, that is, when accounts are adjusted for inflation, then the temporal
method calls for the use of the current exchange rate throughout the balance sheet.
Critique of the Accounting Model of Exposure
Even with the increased flexibility users of accounting information must be aware that
there are three system sources of error that can mislead those responsible for exchange
risk management:
1. Accounting data do not capture all commitments of the firm that give rise to exchange
risk.
2. Because of the historical cost principle, accounting values of assets and liabilities do
not reflect the respective contribution to total expected net cash flow of the firm.
3. Translation rules do not distinguish between expected and unexpected exchange rate
changes.
Regarding the 1st method, it must be recognized that normally, commitments entered into
by the firm in terms of foreign exchange, a purchase or a sales contract, for example, will
not be booked until the merchandise has been shipped. At best, such obligations are
shown as contingent liabilities.
More importantly, accounting data reveals very little about the ability of the firm to
change costs, prices and markets quickly. Alternatively, the firm may be committed by
strategic decisions such as investment in plant and facilities. Such "commitments" are
important criteria in determining the existence and magnitude of exchange risk.
The 2nd method surfaced in our discussion of the temporal method: whenever asset
values differ from market values, translation--however sophisticated--will not redress this
original shortcoming. Thus, many of the perceived problems had their roots not so much
in translation, but in the fact that in an environment of inflation and exchange rate
changes, the lack of current value accounting frustrates the best translation efforts.
Finally, translation rules do not take account of the fact that exchange rate changes have
two components:
1. expected changes that are already reflected in the prices of assets and the costs of
liabilities (relative interest rates); &
2. the real goods and services, the basic rationale for corporate foreign exchange
exposure management is to shield net cash flows, and thus the value of the enterprise,
from unanticipated exchange rate changes.
This thumbnail sketch of the economic foreign exchange exposure concept has a number
of significant implications, some of which seem to be at variance with frequently used
ideas in the popular literature and apparent practices in business firms.
Specifically, there are implications regarding:
1. the question of whether exchange risk originates from monetary or non-

monetary transactions,
2. a revaluation of traditional perspectives such as "transactions risk," &
3. the role of forecasting exchange rates in the context of corporate foreign exchange
risk management.
Contractual versus Non-contractual Returns
An assessment of the nature of the firm's assets and liabilities and their respective cash
flows shows that some are contractual, i.e. fixed in nominal, monetary terms. Such
returns, earnings from fixed interest securities and receivables, for example, and the
negative returns on various liabilities are relatively easy to analyze with respect to
exchange rate changes: when they are denominated in terms of foreign currency, their
terminal value changes directly in proportion to the exchange rate change. Thus, with
respect to financial items, the firm is concerned only about net assets or liabilities
denominated in foreign currency, to the extent that maturities (actually, "durations" of
asset classes) are matched.
What is much more difficult, however, is to gauge the impact of an exchange rate change
on assets with non-contractual returns. While conventional discussions of exchange risk
focus almost exclusively on financial assets, for trading and manufacturing firms at least,
such assets are relatively less important than others. Indeed, equipment, real estate,
buildings and inventories make the decisive contribution to the total cash flow of those
firms. (Indeed companies frequently sell financial assets to banks, factors, or "captive"
finance companies in order to leave banking to bankers and instead focus on the
management of core assets!) And returns on such assets are affected in quite complex
ways by changes in exchange rates. The most essential consideration is how the prices
and costs of the firm will react in response to an unexpected exchange rate change.
For example, if prices and costs react immediately and fully to offset exchange rate
changes, the firm's cash flows are not exposed to exchange risk since they will not be
affected in terms of the base currency.
Currency of denomination versus currency of determination
One of the central concepts of modern international corporate finance is the distinction
between the currency in which cash flows are denominated and the currency that
determines the size of the cash flows. In the example in the previous section, it does not
matter whether, as a matter of business practice, the firm may contract, be invoiced in,
and pay for each individual shipment in its own local currency. If foreign exporters do
not provide price concessions, the cash outflow of the importer behaves just like a foreign
currency cash flow; even though payments are made in local currency, they occur in
greater amounts. As a result, the cash flow, even while denominated in local currency, is
determined by the relative value of the foreign currency. The functional currency concept
introduced in FAS 52 is similar to the "currency of determination" -- but not exactly. The
currency of determination refers to revenue and operating expense flows, respectively;
the functional currency concept pertains to an entity as a whole, and is, therefore, less
precise.
To complicate things further, the currency of recording, that is, the currency in which the
accounting records are kept, is yet another matter. For example, any debt contracted by
the firm in foreign currency will always be recorded in the currency of the country where
the corporate entity is located. However, the value of its legal obligation is established in
the currency in which the contract is denominated.
It is possible, therefore, that a firm selling in export markets may record assets and
liabilities in its local currency and invoice periodic shipments in a foreign currency and
yet, if prices in the market are dominated by transactions in a third country, the cash
flows received may behave as if they were in that third currency. To illustrate: a Brazilian
firm selling coffee to West Germany may keep its records in cruzeiros, invoice in
German marks, and have DM-denominated receivables, and physically collect DM cash
flow, only to find that its revenue stream behaves as if it were in U.S. dollars! This occurs
because DM-prices for each consecutive shipment are adjusted to reflect world market
prices, which, in turn, tend to be determined in U.S. dollars. The significance of this
distinction is that the currency of denomination is (relatively) readily subject to
management discretion, through the choice of invoicing currency. Prices and cash flows,
however, are determined by competitive conditions, which are beyond the immediate
control of the firm.
Yet an additional dimension of exchange risk involves the element of time. In the very
short run, virtually all local currency prices for real goods and services (although not
necessarily for financial assets) remain unchanged after an unexpected exchange rate
change. However, over a longer period of time, prices and costs move inversely to spot
rate changes; the tendency is for Purchasing Power Parity and the Law of One Price to
hold.
In reality, this price adjustment process takes place over a great variety of time patterns.
These patterns depend not only on the products involved, but also on market structure,
the nature of competition, general business conditions, government policies such as price
controls, and a number of other factors. Considerable work has been done on the
phenomenon of "pass-through" of price changes caused by (unexpected) exchange rate
changes. And yet, because all the factors that determine the extent and speed of pass-
through are very firm-specific and can be analyzed only on a case-by-case basis at the
level of the operating entity of the firm (or strategic business unit), generalizations remain
difficult to make. Exhibit 6 summarizes the firm-specific effects of exchange rate
changes on operating cash flows.
Conceptually, though, it is important to determine the time frame within which the firm
cannot react to (unexpected) rate changes by:
(1) raising prices

(2) changing markets for inputs and outputs and/or
(3) adjusting production and sales volumes.
Sometimes, at least one of these reactions is possible within a relatively short time; at
other times the firm is "locked-in" through contractual or strategic commitments
extending considerably into the future. Indeed, those firms that are free to react
instantaneously and fully to adverse (unexpected) rate changes are not subject to
exchange risk.
A further implication of the time-frame element is that exchange risk stems from the
firm's position when its cash flows are, for a significant period, exposed to (unexpected)
exchange rate changes, rather than the risk resulting from any specific international
involvement. Thus, companies engaged purely in domestic transactions but who have
dominant foreign competitors may feel the effect of exchange rate changes in their cash
flows as much or even more than some firms that is actively engaged in exports, imports,
or foreign direct investment.
1.48 EXPOSURE - TYPES AND DESCRIPTION
WHAT IS ECONOMIC EXPOSURE?
Economic exposure is tied to the currency of determination of revenues and costs.
M/s PDVSA, the Venezuelan state-owned oil company, recently set up an oil refinery
near Rotterdam, The Netherlands, for shipment to Germany and other continental
European countries. The firm planned to invoice its clients in ECU, the official currency
unit of the European Community.
How the treasurer will source long term financing ?
In the past all long-term finance has been provided by the parent company, but working
capital required to pay local salaries and expenses has been financed in Dutch guilders.
The treasurer is not sure whether the short-term debt should be hedged, or what currency
to issue long term debt in. This is an example of a situation where the definition of
exposure has a direct impact on the firm's hedging decisions.
Economic exposure is tied to the currency of determination of revenues and costs. Since
the world market price of oil is dollars, this is the effective currency in which PDVSA's
future sales to Germany are made. If the ECU rises against the dollar, PDVSA must
adjust its ECU price down to match those of competitors like Aramco. If the dollar rises
against the ECU, PDVSA can and should raise prices to keep the dollar price the same,
since competitors would do likewise. Clearly the currency of determination is influenced
by the currency in which competitors denominate prices.
WHAT IS TRANSALATION EXPOSURE?
Translation exposure has to do with the location of the assets.

In this case it would be a totally misleading measure of the effect of exchange rate
changes on the value of the unit. After all, the oil comes from Venezuela and is shipped
to Germany: its temporary resting place, be it a refinery in Rotterdam or a tanker en route
to Germany, has no import. Both provide value added, but neither determine the currency
of revenues. So financing should definitely not be done in Dutch guilders.
WHAT IS TRANSACTION EXPOSURE?
Transactions exposure has to do with the currency of denomination of assets like

accounts receivable or payable.
Ex : Once sales to Germany have been made and invoicing in ECU has taken place,
PDVSA-Netherlands has contractual, ECU-denominated assets that should be financed or
hedged with ECU. For future sales, however, PDVSA-Netherlands does not have
exposure to the ECU. This is because the currency of determination is the U.S. dollar.
1.49 MANAGING ECONOMIC EXPOSURE
(a) Economic Effects of Unanticipated Exchange Rate Changes on Cash Flows
From this analytical framework, some practical implications emerge for the assessment of
economic exposure. First of all, the firm must project its cost and revenue streams over a
planning horizon that represents the period of time during which the firm is "locked-in,"
or constrained from reacting to (unexpected) exchange rate changes. It must then assess
the impact of a deviation of the actual exchange rate from the rate used in the projection
of costs and revenues.
1.50 STEPS IN MANAGING ECONOMIC EXPOSURE
1. Estimation of planning horizon as determined by reaction period.
2. Determination of expected future spot rate.
3. Estimation of expected revenue and cost streams, given the expected spot rate.
4. Estimation of effect on revenue and expense streams for unexpected exchange rate
changes.
5. Choice of appropriate currency for debt denomination.
6. Estimation of necessary amount of foreign currency debt.
7. Determination of average interest period of debt.
8. Selection between direct or indirect debt denominations.
9. Decision on trade-off between arbitrage gains vs. exchange risk stemming from
exposure in markets where rates are distorted by controls.
10. Decision about "residual" risk: consider adjusting business strategy.
Subsequently, the effects on the various cash flows of the firm must be netted over
product lines and markets to account for diversification effects where gains and losses
could cancel out, wholly or in part. The remaining net loss or gain is the subject of
economic exposure management.
For a multiunit, multi-product,multi-national corporation the net exposure may not be

very large at all because of the many offsetting effects. And by contrast, enterprises that
have invested in the development of one or two major foreign markets are typically
subject to considerable fluctuations of their net cash flows, regardless of whether they
invoice in their own or in the foreign currency.
For practical purposes, three questions capture the extent of a company's foreign
exchange exposure.
1. How quickly can the firm adjust prices to offset the impact of an unexpected
exchange rate change on profit margins?
2. How quickly can the firm change sources for inputs and markets for outputs? Or,
alternatively, how diversified are a company's factor and product markets?
3. To what extent do volume changes, associated with unexpected exchange rate changes,
have an impact on the value of assets?
Normally, the executives within business firms who can supply the best estimates on
these issues tend to be those directly involved with purchasing, marketing, and
production. Finance managers who focus exclusively on credit and foreign exchange
markets may easily miss the essence of corporate foreign exchange risk.
Financial versus operating strategies for Hedging
When operating (cash) inflows and (contractual) outflows from liabilities are affected by
exchange rate changes, the general principle of prudent exchange risk management is:
Any effect on cash inflows and outflows should cancel out as much as possible. This can
be achieved by maneuvering assets, liabilities or both. When should operations -- the
asset side -- be used?
We have seen that exchange rate changes can have tremendous effects on operating cash
flows. Does it not therefore make sense to adjust operations to hedge against these
effects? Many companies, such as Japanese auto producers, are now seeking flexibility in
production location, in part to be able to respond to large and persistent exchange rate
changes that make production much cheaper in one location than another. Among the
operating policies is the shifting of markets for output, sources of supply, product-lines,
and production facilities as a defensive reaction to adverse exchange rate changes.
Put differently, deviations from purchasing power parity provide profit opportunities for
the operations-flexible firm. This philosophy is epitomized in the following quotation.
It has often been joked at Philips that in order to take advantage of currency movements,
it would be a good idea to put our factories aboard a supertanker, which could put down
anchor wherever exchange rates enable the company to function most efficiently. In the
present currency markets...[this] would certainly not be a suitable means of transport for
taking advantage of exchange rate movements. An aeroplane would be more in line with
the requirements of the present era.
The problem is that Philips' production could not fit into either craft. It is obvious that
such measures will be very costly, especially if undertaken over a short span of time. it
follows that operating policies are not the tools of choice for exchange risk management.
Hence operating policies, which have been designed to reduce or eliminate exposure, will
only be undertaken as a last resort, when less expensive options have been exhausted.
It is not surprising, therefore, that exposure management focuses not on the asset side, but
primarily on the liability side of the firm's balance sheet. Whether and how these steps
should be implemented depends first, on the extent to which the firm wishes to rely on
currency forecasting to make hedging decisions, and second, on the range of hedging
tools available and their suitability to the task.
1.51 Guidelines for Corporate Forecasting of Exchange Rates
Academics and practitioners have sought the determinants of exchange rate changes ever
since there were currencies. Many students have learned about the balance of trade and
how the more a country exports, the more demand there is for its currency, and so the
stronger is its exchange rate. In practice, the story is a lot more complex. Research in the
foreign exchange markets have come a long way since the days when international trade
was thought to be the dominant factor determining the level of the exchange rate.
Monetary variables, capital flows, rational expectations and portfolio balance are all now
understood to factor into the determination of currencies in a floating exchange rate
system.
Many models have been developed to explain and to forecast exchange rates. No model
has yet proved to be the definitive one, perhaps because the structure of the world’s
economies and financial markets are undergoing such rapid evolution.
Corporations nevertheless avidly seek ways to predict currencies, in order to decide when
and when not to hedge. The models they use are typically one or more of the following
kinds:
1. political event analysis

2. fundamental
3. technical
Exchange rates react quickly to news. Rates are far more volatile than changes in
underlying economic variables; they are moved by changing expectations, and hence are
difficult to forecast. In a broad sense they are "efficient," but tests of efficiency face
inherent obstacles in testing the precise nature of this efficiency directly.
The central "efficient market" model is the unbiased forward rate theory introduced
earlier. It says that the forward rate equals the expected future level of the spot rate.
Because the forward rate is a contractual price, it offers opportunities for speculative
profits for those who correctly assess the future spot price relative to the current forward
rate.
Specifically, risk neutral players will seek to make a profit their forecast differs from the
forward rate, so if there are enough such participants
the forward rate will always be bid up or down until it equals the expected future spot.
Because expectations of future spot rates are formed on the basis of presently available
information (historical data) and an interpretation of its implication for the future, they
tend to be subject to frequent and rapid revision.
The actual future spot rate may therefore deviate markedly from the expectation
embodied in the present forward rate for that maturity. The actual exchange rate may
deviate from the expected by some random error.
Another way of looking at these errors to consider them as speculative profits or losses:
what you would gain or lose of you consistently bet against the forward rate. Can they be
consistently positive or negative? A priori reasoning suggests that this should not be the
case. Otherwise one would have to explain why consistent losers do not quit the market,
or why consistent winners are not imitated by others or do not increase their volume of
activity, thus causing adjustment of the forward rate in the direction of their expectation.
Barring such explanation, one would expect that the forecast error is sometimes positive,
sometimes negative, alternating in a random fashion, driven by unexpected events in the
economic and political environment.
Forecasting exchange rate changes, however, is important for planning purposes. To the
extent that all significant managerial tasks are concerned with the future, anticipated
exchange rate changes are a major input into virtually all decisions of enterprises
involved in and affected by international transactions.
However, the task of forecasting foreign exchange rates for planning and decision-
making purposes, with the purpose of determining the most likely exchange rate, is quite
different from attempting to beat the market in order to derive speculative profits.
Expected exchange rate changes are revealed by market prices when rates are free to
reach their competitive levels. Organized futures or forward markets provide inexpensive
information regarding future exchange rates, using the best available data and judgment.
Thus, whenever profit-seeking, well-informed traders can take positions, forward rates,
prices of future contracts, and interest differentials for instruments of similar riskiness
(but denominated in different currencies), provide good indicators of expected exchange
rates. In this fashion, an input for corporate planning and decision-making is readily
available in all currencies where there are no effective exchange controls.
The advantage of such market-based rates over "in-house" forecasts is that they are both
less expensive and more likely to be accurate. Those who tend to have the best
information and track record determine market rates; incompetent market participants
lose money and are eliminated.
The nature of this market-based expected exchange rate should not lead to confusing
notions about the accuracy of prediction. In speculative markets, all decisions are made
on the basis of interpretation of past data; however, new information surfaces constantly.
Therefore, market-based forecasts rarely will come true. The actual price of a currency
will either be below or above the rate expected by the market. If the market knew which
would be more likely, any predictive bias quickly would be corrected. Any predictable,
economically meaningful bias would be corrected by the transactions of profit-seeking
transactors.
Example: Hedging with a Forward Contract
Janet Fredericks, Foreign Exchange Manager at M/s Murray Chemical, was informed that
Murray was selling 25,000 tones of Naphtha to Canada for a total price of C$11,500,000,
to be paid upon delivery in two months' time. To protect her company, she arranged to
sell 11.5 million Canadian dollars forward to the Royal Bank of Montreal. The two-
month forward contract price was US$0.8785 per Canadian dollar.
Two months and two days later, Fredericks received US$10,102,750 from RBM and
paid RBM C$11,500,000, the amount received from Murray's customer.
The importance of market-based forecasts for a determination of the foreign exchange

exposure of the firm is that of a benchmark against which the economic consequences of
deviations must be measured. This can be put in the form of a concrete question: How
will the expected net cash flow of the firm behave if the future spot exchange rate is not
equal to the rate predicted by the market when commitments are made? The nature of this
kind of forecast is completely different from trying to outguess the foreign exchange
markets.
1.52 Tools And Techniques For The Management Of Foreign Exchange Risk
In this section we consider the relative merits of several different tools for hedging
exchange risk, including forwards, futures, debt, swaps and options. We will use the
following criteria for contrasting the tools.
First, there are different tools that serve effectively the same purpose. Most currency
management instruments enable the firm to take a long or a short position to hedge an
opposite short or long position. Thus one can hedge a DM payment using a forward
exchange contract, or debt in DM, or futures or perhaps a currency swap. In equilibrium
the cost of all will be the same, according to the fundamental relationships of the
international money market as illustrated in Exhibit 1. They differ in details like default
risk or transactions costs, or if there is some fundamental market imperfection. Indeed in
an efficient market one would expect the anticipated cost of hedging to be zero. This
follows from the unbiased forward rate theory.
Second, tools differ in that they hedge different risks. In particular, symmetric hedging
tools like futures cannot easily hedge contingent cash flows: options may be better suited
to the latter.
Tools and techniques: Foreign Exchange Forwards
Foreign exchange is, of course, the exchange of one currency for another. Trading or
"dealing" in each pair of currencies consists of two parts, the spot market, where payment
(delivery) is made right away (in practice this means usually the second business day),
and the forward market.
FOREIGN EXCHANGE MARKET

1.53 Structure of the Forex Market:
• Retail market in which travelers and tourists exchange one currency for another in
the form of currency notes or travelers cheques. The spread between buying and selling
is large.
• Wholesale market or inter-bank market where in the participants is commercial
banks, corporates and central banks.
1.54 Market Players:
• The primary price makers (professional dealers) who make a two-way market to
each other and to the clients, comprise of commercial banks, investment dealers and large
corporates.
• Among the primary price makers there is a kind of tie ring a few giant
multinational banks deal in large currencies in large amounts and often deal directly with
each other without brokers thus, influencing the market. The next tier may comprise of
large banks that deal in restricted number of currencies and use brokers. The last tier
may comprise of small local institutions and deal in very small number of major
currencies against the home currency.
• Foreign currency brokers act as middleman and provide information to market
making banks about prices at which there are firm buyers and sellers in a pair of
currencies.
• Brokers also play the role of "showing" the market anonymously the prices from
the price makers.
• Central banks intervene in the market from time to time and attempt to move the
exchange rates in the targeted direction.
• Over 90% of the transaction is accounted for by inter-bank transactions.
1.55 Mechanics of Currency Trading:

• ISO has developed three letter codes for all the currencies (USD, INR, JPY, CHF,
DEM, GBP, FRF, etc.)
• Inter-bank dealing for a typical SPOT transaction could be something like
Bank A: Bank A calling. Your price on Mark - Dollar please.
Bank B: Forty, Forty-Eight.
Bank A: Ten Dollars Mine at Forty-Eight.
• Bank B is offering rate of 1.4540 / 1.4548
• Bank B is willing to pay DM 1.4540 for every USD it buys.
• It will charge DM 1.4548 for every USD it sells.
• The spread is 8 points. The difference between bid and offered rates.
• DM 1.45 is the "big figure" and hence only last two figures are quoted namely 40
and 48.
• Bank A wants to buy Dollars against the DM and he conveys this in the third line,
which means that "I buy 10 million Dollars at your offer price of DM 1.4548 per Dollar".
• Bank B is then said to have been "hit" on its offer side.
• If Bank A wanted to sell USD 5 million, he would have said "Five Dollars yours
at Forty".
1.56 Types of Transactions and Settlement Dates:
• Settlement of a transaction takes place by transfers of deposits between the two

parties. The day on which these transfers are effected is called "Settlement Date or Value
Date".
• The dealing locations need not necessarily be the settlement locations.
• Depending upon the time elapsed between transaction date and the settlement
date; the foreign exchange transaction can be categorized in to SPOT or Forward. Yet
another category is called swap, which is a combination of SPOT and Forward
transaction.
• In a SPOT transaction the settlement or value date is usually two business days
ahead for European currencies or Yen traded against the Dollar. The two-day gap is
necessary for confirming and clearing the deal through the communication network such
as SWIFT.
• Value Dates for Forward Transaction: This is arrived at by adding one calendar
month to the Value Date for a SPOT transaction between the two currencies. Should this
be a holiday, the next working day is considered.
• Forward maturities are normally for whole month however; banks often quote
"broken date" or "odd date" contract (73 days).
• A swap transaction is a combination of SPOT and Forward in the opposite
direction. Thus a bank will buy DM SPOT against USD and simultaneously enter into a
Forward transaction with the same counter party to sell DM against USD, keeping the
amount of one of the currencies fixed.
• It is a temporary exchange of one currency for another with an obligation to
reverse it at a specific future date.
1.57 Arbitrage between Banks:

• Not all banks have identical quotation for a given pair of currencies at a given
point of time. Suppose banks A and B are quoting for Dollar against Pound 1.4550 / 60
and 1.4538 / 48, it can give rise to arbitrage opportunity as follows:
? Buy Pounds at $1.4548 from B.

? Sell Pounds at $1.4550 to A.
? Earn Net Profit of $0.0002 per Pound till bank B raises its offer rates and/or bank
A lowers its bid rates.
• Thus the two quotes must overlap by at least 1 point to prevent arbitrage. Say that
bank B increases its' rates to $1.4545 / 55, the arbitrage opportunity vanishes. However,
bank A will find that it is "being hit" on its bid side much more often whereas bank B
will find that it is confronted largely with buyers of Pound and very few sellers.
• From time to time banks deliberately move its quotations to discourage one type
of transaction and encourage the opposite, if this is not done, bank A would have built a
large net short position in Pound and may now want to encourage sellers of Pound and
discourage buyers. Bank B would be in the opposite position.
1.58 Inverse quotes and 2-point arbitrage
• Suppose a Zurich bank offers a SPOT quotation:

CHF / Dollar = 1.4955 / 62
• At the same time, a New York bank offers the following quote:
USD / CHF = 0.6695 / 99
• Buying One Million Swiss Franks from Zurich bank means $ 1000000 /
1.4955 = US$ 668700 to acquire Swiss Franks.
• Sell One Million Swiss Franks in New York and earn US$ 669500 in New York.
• Couple of phone calls and risk less profit of $ 800, clearly indicating that the two
bank quotations are out of line. This arbitrage transaction is called "two point arbitrage"
and foreign exchange markets very quickly eliminate such opportunities if and when they
arise.
• (USD / CHF) ask is the rate that applies when bank sells Swiss Franks in
exchange for Dollars.
• To avoid arbitrage, the following must hold:
Implied (USD / CHF) bid = 1/(CHF / USD) ask
Implied (USD / CHF) ask = 1/(CHF / USD) bid
1.59 Outright Forward Quotations
• Quotations for such transactions are given in the same manner as SPOT
quotations.
Thus a quote like:

FRF / USD 3 month Forward: 4.4570 / 95 means Bank will give FRF 4.4570 to buy a
USD, delivery 3 months from the corresponding SPOT value date.
1.60 Discounts and Premia in the Forward Market

• Consider the following pair of quotations:

DM / USD SPOT: 1.5677 / 85
DM / USD 1 month Forward: 1.5575 / 85
• Dollar is cheaper for delivery after 1-month compare to SPOT. The Dollar is said
to be at a Forward discount against DM or DM at a Forward premium in relation to
Dollar.
1.61 Annualized Premium / Discount:
• Annualized percentage discount / premium is calculated as:

[Forward(DEM/USD)mid - SPOT(DEM/USD)mid ] * 12 * 100
SPOT(DEM/USD)mid
• In the above example, the discount will work out to
= (1.5580 - 1.5681) * 12 * 100 / 1.5681
= - 7.73%
1.62 Margin Requirement:
• Forward contract between 2 banks involves telephonic agreement on price,

amount and period.
• When bank enters into Forward deal with corporate, it has to protect against
default in commitment.
• Done through either allocate credit limit or cash deposit.
1.63 FORWARD CONTRACTS, FUTURES & CURRENCY OPTIONS

1.63.1 Forward Contract
The rate in the forward market is a price for foreign currency set at the time the
transaction is agreed to but with the actual exchange, or delivery, taking place at a
specified time in the future. While the amount of the transaction, the value date, the
payments procedure, and the exchange rate are all determined in advance, no exchange of
money takes place until the actual settlement date. This commitment to exchange
currencies at a previously agreed exchange rate is usually referred to as a Forward
Contract.
Forward contracts are the most common means of hedging transactions in foreign
currencies. The trouble with forward contracts, however, is that they require future
performance, and sometimes one party is unable to perform on the contract. When that
happens, the hedge disappears, sometimes at great cost to the hedger. This default risk
also means that many companies do not have access to the forward market in sufficient
quantity to fully hedge their exchange exposure. For such situations, futures may be more
suitable.
Example
Suppose XYZ Ltd needs US $ 3,00,000 on 1st May 2000 for repayment of loan
installment and interest. As on 1st December 1999, it appears to the company that the US
$ may be dearer as compared to the exchange rate prevailing on that date, say US $ 1 =
Rest. 43.50. Accordingly, XYZ Ltd may enter into a forward contract with a banker for
US $ 3,00,000. The forward rate may be higher or lower than the spot rate prevailing on
the date of the forward contract. Let us assume forward rate as on 1st December 1999
was US$ 1 = Rest. 44 as against the spot rate of Rest. 43.50. As on the future date, i.e.,
1st May 2000, the banker will pay XYZ Ltd $ 3,00,000 at Rest. 44 irrespective of the
spot rate as on that date. Let us assume that the Spot rate as on that date be US $ 1 = Rest.
44.80
In the given example XYZ Ltd gained Rest. 2,40,000 by entering into the forward
contract.
Payment to be made as per forward contract

(US $ 3,00,000 * Rs.44.00)
Rs.132, 00,000
Amount payable had the forward contract not been in place

(US $ 3,00,000 * Rs.44.80)
Rs.134, 40,000
Gain arising out of the forward exchange contract

Rs.240, 000
1.63.2 Currency Futures
Outside of the interbank forward market, the best-developed market for hedging
exchange rate risk is the currency futures market.
In principle, currency futures are similar to foreign exchange forwards in that they are
contracts for delivery of a certain amount of a foreign currency at some future date and at
a known price. In practice, they differ from forward contracts in important ways.
1. One difference between forwards and futures is standardization. Forwards are for any
amount, as long as it's big enough to be worth the dealer's time, while futures are for
standard amounts, each contract being far smaller that the average forward transaction.
2. Futures are also standardized in terms of delivery date. The normal currency futures
delivery dates are March, June, September and December, while forwards are private
agreements that can specify any delivery date that the parties choose. Both of these
features allow the futures contract to be tradable.
3. Another difference is that forwards are traded by phone and telex and are completely
independent of location or time. Futures, on the other hand, are traded in organized
exchanges such the LIFFE in London, SIMEX in Singapore and the IMM in Chicago.
4. But the most important feature of the futures contract is not its standardization or
trading organization but in the time pattern of the cash flows between parties to the
transaction. In a forward contract, whether it involves full delivery of the two currencies
or just compensation of the net value, the transfer of funds takes place once: at maturity.
With futures, cash changes hands every day during the life of the contract, or at least
every day that has seen a change in the price of the contract. This daily cash
compensation feature largely eliminates default risk.
Thus, forwards and futures serve similar purposes, and tend to have identical rates, but
differ in their applicability. Most big companies use forwards; futures tend to be used
whenever credit risk may be a problem.
1.63.3 Debt instead of forwards or futures
Debt -- borrowing in the currency to which the firm is exposed or investing in interest-
bearing assets to offset a foreign currency payment -- is a widely used hedging tool that
serves much the same purpose as forward contracts.
An example :
Elizabeth sold Canadian dollars forwards. Alternatively she could have used the
Eurocurrency market to achieve the same objective. She would borrow Canadian dollars,
which she would then change into francs in the spot market, and hold them in a US dollar
deposit for two months. When payment in Canadian dollars was received from the
customer, she would use the proceeds to pay down the Canadian dollar debt. Such a
transaction is termed a money market hedge.
The cost of this money market hedge is the difference between the Canadian dollar
interest rate paid and the US dollar interest rate earned.
According to the interest rate parity theorem, the interest differential equals the forward
exchange premium, the percentage by which the forward rate differs from the spot
exchange rate. So the cost of the money market hedge should be the same as the forward
or futures market hedge, unless the firm has some advantage in one market or the other.
The money market hedge suits many companies because they have to borrow anyway, so
it simply is a matter of denominating the company's debt in the currency to which it is
exposed that is logical. But if a money market hedge is to be done for its own sake, as in
the example, the firm ends up borrowing from one bank and lending to another, thus
losing on the spread.
This is costly, so the forward hedge would probably be more advantageous except where
the firm had to borrow for ongoing purposes anyway.
1.63.4 Currency Options
Many companies, banks and governments have extensive experience in the use of
forward exchange contracts. With a forward contract one can lock in an exchange rate for
the future.
There are a number of circumstances, however, where it may be desirable to have more
flexibility than a forward provides. For example a computer manufacturer in California
may have sales priced in U.S. dollars as well as in German marks in Europe. Depending
on the relative strength of the two currencies, revenues may be realized in either German
marks or dollars.
In such a situation the use of forward or futures would be inappropriate: there's no point
in hedging something you might not have. What is called for is a foreign exchange
option: the right, but not the obligation, to exchange currency at a predetermined rate.
Defn. : A foreign exchange option is a contract for future delivery of a currency in

exchange for another, where the holder of the option has the right to buy (or sell) the
currency at an agreed price, the strike or exercise price, but is not required to do so. The
right to buy is a call; the right to sell, a put. For such a right he pays a price called the
option premium. The option seller receives the premium and is obliged to make (or take)
delivery at the agreed-upon price if the buyer exercises his option. In some options, the
instrument being delivered is the currency itself; in others, a futures contract on the
currency. American options permit the holder to exercise at any time before the
expiration date; European options, only on the expiration date.
Example
Steve of Jackson Agro just agreed to purchase 15 million worth of potatoes from his
supplier in County Cork, Ireland. Payment of the five million punt was to be made in 245
days' time. The dollar had recently plummeted against all the EMS currencies and Steve
wanted to avoid any further rise in the cost of imports. He viewed the dollar as being
extremely instable in the current environment of economic tensions. Having decided to
hedge the payment, he had obtained dollar/punt quotes of $2.25 spot, $2.19 for 245 days
forward delivery. His view, however, was that the dollar was bound to rise in the next
few months, so he was strongly considering purchasing a call option instead of buying
the punt forward. At a strike price of $2.21, the best quote he had been able to obtain
was from the Ballad Bank of Dublin, who would charge a premium of 0.85% of the
principal.
Steve decided to buy the call option. In effect, he reasoned, I'm paying for downside
protection while not limiting the possible savings I could reap if the dollar does recover
to a more realistic level. In a highly volatile market where crazy currency values can be
reached, options make more sense than taking your chances in the market, and you're not
locked into a rock-bottom forward rate.
This simple example illustrates the lopsided character of Options.

1.63.5 Swap
• A SWAP transaction between currencies A & B consists of a SPOT purchase

(sale) of A coupled with a Forward sale (purchase) of A, both against B. The amount of
one of the two currencies is identical in SPOT and Forward
• The banks quote and do outright Forward deals with non-bank customers. The
Forward deals are done in inter-bank market in the form of SWAP
• Assume that a bank buys Pounds one month Forward against Dollars from a
customer. It has thus created long position in Pounds and short in Dollars.
If it wants to square it up, it will do as follows:
A Swap in which it buys Pounds Spot and sells one month Forward, thus creating an
offsetting short Pound position one month Forward.
Coupled with a Spot sell of Pounds to offset the long Pound position in Spot created in
the above Swap.
The reason for this is that it is very difficult to find counter parties with matching
opposite news to cover the original position by an opposite outright Forward.
How to derive Outright Forward from swap quotation?
• Suppose DEM / USD SPOT is 1.6265 / 75 and 1-month swap is 15/8 (15/8 is in
"points") point = 10-4
• To arrive at implied Forward, 15 points to be added to or subtracted from SPOT
bid rate and 8 points to be added / subtracted from SPOT ask.
• How to determine whether to add or subtract? The answer guided by two
principles
o The bank must always profit. Rate at which it sells a currency must be > buys
same currency.
o Bid and ask spread widens as we go farther and farther into future.
In the above example if we add swap points, we will have 1-month Forward rate as
1.6280 / 83. This is in conformity with first principle but violets second.
1.63.6 Cross Rates
In case the price of one currency is not quoted angst the other currency the parity between
them is obtained by using an intermediary currency. The rate thus obtained is called a
cross rate and the principle applied for obtaining the cross rate is called the chain rule.
Ex:
Say in the Indian market the US dollar is quoted is at USD 1 = 35.8675/8725
In case the DM is quoted in New York as 1 USD = DM 1.5900/5910

1 DM = Rs.22.5582, If 1.5910DM= 1 USD and 1 USD = Rs.35.8675 then the answer for
1DM would be = Rs.22.5540
Similarly, if the cross rate currency for any currency is known then it is possible to arrive
at the rate of the desired currency.
1.63.7 Controlling Corporate Treasury Trading Risks
In a corporation, there is no such thing as being perfectly hedged. Not every transaction
can be matched, for international trade and production is a complex and uncertain
business. As we have seen, even identifying the correct currency of exposure, the
currency of determination, is tricky. Flexibility is called for, and management must
necessarily give some discretion, perhaps even a lot of discretion, to the corporate
treasury department or whichever unit is charged with managing foreign exchange risks.
Some companies, feeling professionals best handle that foreign exchange, hire ex-bank
dealers; other groom engineers or accountants. Yet however talented and honorable are
these individuals, it has become evident that some limits must be imposed on the trading
activities of the corporate treasury, for losses can get out of hand even in the best of
companies.
In 1992 a Wall Street Journal reporter found that Dell Computer Corporation, a star of the
retail PC industry, had been trading currency options with a face value that exceeded
Dell's annual international sales, and that currency losses may have been covered up.
Complex options trading were in part responsible for losses at the treasury of Allied-
Lyons, the British foods group. The $150 million lost almost brought the company to its
knees, and the publicity precipitated a management shakeout.
In 1993 the oil giant Royal Dutch-Shell revealed that currency trading losses of as much
as a billion dollars had been uncovered in its Japanese subsidiary.
Clearly, performance measurement standards, accountability and limits of some form

must be part of a treasury foreign currency-hedging program. Space does not permit a
detailed examination of trading control methods, but some broad principles can be stated.
First, management must elucidate the goals of exchange risk management, preferably in
operational terms rather than in platitudes such as "we hedge all foreign exchange risks."
Second, the risks of in-house trading (for that's often what it is) must be recognized.
These include losses on open positions from exchange rate changes, counter party credit
risks, and operations risks.
Third, for all net positions taken, the firm must have an independent method of valuing,
marking-to-market, the instruments traded. This marking to market need not be included
in external reports, if the positions offset other exposures that are not marked to market,
but is necessary to avert hiding of losses. Wherever possible, marking to market should
be based on external, objective prices traded in the market.
Fourth, position limits should be made explicit rather than treated as "a problem we
would rather not discuss." Instead of hamstringing treasury with a complex set of rules,
limits can take the form of prohibiting positions that could incur a loss (or gain) beyond a
certain amount, based on sensitivity analysis. As in all these things, any attempt to cover
up losses should reap severe penalties.
Finally, counter party risks resulting from over-the-counter forward or swap contracts
should be evaluated in precisely the same manner as is done when the firm extends credit
to, say, suppliers or customers.
1.64 Market Forecasts
After determining its Exposures, the company has to form an idea of where the market is
headed.
The company will focus on forecasts for the next 6 months, as forecasts for periods
beyond 6 months can be unreliable.
The focus of the Apex Management is to be aware of the Direction or the Big Trend in
rates
• the underlying assumptions behind the forecasts
• the Probability that can be assigned to the forecast coming true
• the possible extent of the move
The Risk Appraisal exercise and Benchmarking decisions will be based on such forecasts
1.65 Market Participants
• OTC Nature - Trades effected on phone, fax or electronically.

• Major banks act as "market makers".
• Two way quotes - rate at which willing to buy and sell one currency for another
(bid and offered rates). 9 digit dollars.
• Cross currency rates done by utilizing the dollar.
1.66 Market Participants - 4 Categories

• Non-bank entities that wish to exchange currencies to meet or hedge contractual
commitments (for import or export contracts).
• Banks, which exchange currencies to meet requirements of their clients.
• Speculators buying or selling currencies. These speculators comprise of large
commercial banks, MNCs and hedge funds.
• Arbitragers - limited role due to communication systems.
1.67 Hedge Funds
• Investment vehicles for wealthy individuals. Popular in US and privately placed.

Total capital is US $ 300 billion.
• "Short" sell say (overpriced) silver and simultaneously (under priced) gold. The
term overpriced and under priced refer to relative ruling prices in comparison to past. The
objective is to make profit when prices revert to historical relationship.
• Hedge funds typically operate on 10% margin and leverage fund corpus 10 times.
Hence, far greater degree of risk and reward.
• Unlike MFs, no supervision or regulation and lack of disclosure.
• Fund manager fees are typically 15 to 20% of profits.
1.68 Dealing Rooms
• Banks in major money markets investing heavily in computer and communication

infrastructure for efficient functioning of trading room.
• Integrated dealing rooms, which handle not only foreign exchange but also
derivatives like swaps, futures and options.
• MNCs too are in the market not only for covering their own exposures but
actively speculating on currency movements and making treasury management as profit
center.
1.69 Information Systems
• Reuter monetary service introduced in 1973 - bid and offered quotations now far
greater coverage and sophistications.
• Other real time financial data providers are Bloomberges.
• Deals are allowed to be struck and settlement instructions given through system.
• Reuters 3000 provides dealing system + electronic broker by matching the quoted
rates of subscribing banks.
• Rapid growth of cheap and electronic broking facilitates instant deal
confirmations and has replaced traditional voice brokers.
• 24 hours open dealing rooms to take care of all time zones.
• Internet further revolutionizing the system.
1.70 Payment and Communication System

• Once deal is "done", the dealers simultaneously specify where they want
currencies to be delivered.
• No paper-based system can meet the needs.
• Electronic or automated interbank fund transfer system like CHIPS(clearing
house interbank payment system) in New York.
1.71 Risk Appraisal
This exercise is aimed at determining where the company's exposures stand vis-à-vis
market forecasts.
The following Risks will be considered.
1. Risk to the Exposure or Value at Risk (VAR)
Given a particular view or forecast, VAR tries to determine by how much the company’s
underlying cash flows are affected. The VAR is the answer to the question, “If the Rate
actually moves to xx.xxxx, how much Profit/ Loss does the company make?”
2. Forecast Risk
What is the likelihood of the rate actually moving to xx.xxxx and what is the likelihood
of a forecast going wrong. It is imperative to know this before deciding on a Benchmark
and devising a hedging strategy.
3. Market and Transaction Risk
This will take into consideration the risks attached with each particular market and the
likelihood of a transaction not going through smoothly. For instance, The Rupee is given
to sudden swings in sentiment, whereas the Deutschemark is generally more predictable.
The monetary and time costs of hedging with a nationalised bank are generally higher
than with a private/ foreign bank.
4. Systems Risk
The risks that arise through gaps or weaknesses in the Exposure Management system. For
example:
Reporting Gapwhere there are delays/ errors in reporting exposures to the Exposure
Management cell
Implementation Gap where there is a gap between the decision to hedge and the
implementation of such hedge decision.
The company will endeavor to reduce the non-market risk or Systems Risk over time.
1.72 Benchmarking
This exercise aims to state where the company would like its exposures to reach.
1. The company will set a Benchmark for its Exposure Management practices.
2. The Benchmarks will be set for 6 months periods.
3. The Benchmark will reflect and incorporate the following:
The Objective of Exposure Management, or in other words, "Should Exposure
Management be conducted on a Profit Center or Cost Center basis?"
The Forecasts discussed and agreed upon earlier. Mathematically, the Benchmark should
be the Probabilistic Expectation of the rate in question. The Forecast risk, Market and
Transaction risk, and Systems
risk as determined earlier.
Room for error in keeping with the Stop Loss Policy to be decided
4. The Benchmark will be realistic and achievable.
Suggestions:
Companies whose exposures are of long-term Capital nature can look to manage them on
a Profit Center basis, since the exposures are not open to day-to-day business risks.
Companies whose exposures are of short-term Revenue nature should manage them on a
Cost Center basis, since the exposures impact the P&L Account directly.
A small note on the Profit/ Cost center concept:
Profit Center Under this concept, the Exposure Manager is required to generate a NET
profit on the exposure over time. This is an aggressive stance implying a high degree of
risk appetite on the part of Apex Management. A company with a strong position in its
daily bread and butter business can afford to take some financial risks and can opt for this
concept.
The Benchmarks under a Profit-Center concept would take the form of “The total cost of
a foreign currency loan should be reduced by at least 25 bp over a one year period, from
the forecasted rate of x.x % p.a.”.
Cost Center Under this concept, the Exposure Manager would be required to ensure
that the cash flows of the company are not adversely affected beyond a certain point. This
is a defensive strategy, implying a lower risk appetite. A company whose cash flows are
volatile, or whose underlying business is not on a very sound footing would be advised to
adopt this concept.
The Benchmarks under a Cost-Center concept would take the form of “Foreign Exchange
fluctuations should add no more than x% to the cost of Imported Raw Material over and
above the budgeted cost.”
1.73 Hedging
This is the most visible and glamourised part of the Exposure Management function.
However, the Trader is like the Driver in a car rally, who needs to follow the general
directions of the Navigator.
a. Hedging strategies will be designed to meet the Exposure Management
objectives, as represented by the Benchmarks
b. The Exposure Management Cell will be accorded full operational freedom to

carry out the hedging function on a day to day basis
c. Hedges will be undertaken only after appropriate Stop-Loss and Take-Profit
levels have been predetermined
d. The company will use all hedging techniques available to it, as per need and
requirement. In this regard, it will pass a Board Resolution authorising the use of the
following:
? Rupee-Foreign Currency Forward Contracts
? Cross Currency Forward Contracts
? Forward-to-Forward Contracts
? FRAs
? Currency Swaps
? Interest Rate Swaps
? Currency Options
? Interest Rate Options
? Others, as may be required
Suggestion:
Indian companies with sizeable US Dollar denominated exposures are extremely
vulnerable to sudden drastic moves in the USD-INR rate. They can, to an extent, insulate
themselves from such shocks by undertaking hedges in currencies other than Rupee-
Dollar.
For instance, a Dollar payable can be hedged by selling a currency (say Sterling Pound)
in order to buy Dollars, instead of selling the Rupee. The choice of currency would, of
course, depend on the trend and forecast for the currency(s) at that point of time.
It is easier and safer to generate profits from a Cross-Currency Forward Contract and a
Rest 1 Lac profit thereon is equivalent to saving a 10 paise depreciation in the Rupee (on
USD 1 million)
1.74 Stop Loss

Exposure Management should not be undertaken without having a Stop-Loss policy in
place. A Stop-Loss policy is based on the following two fundamental principles:
1. To err is human
2. A stitch in time saves nine
It is appropriate to recount here some words from a speech of Dr Alan Greenspan,
Chairman of the US Federal Reserve, delivered in December 1997, on the Asian financial
crisis. He says,
“There is a significant bias in political systems of all varieties to substitute hope (read,
wishful thinking) for possibly difficult pre-emptive policy moves. There is often denial
and delay in instituting proper adjustments……Reality eventually replaces hope and the
cost of the delay is a more abrupt and disruptive adjustment than would have been
required if action had been more preemptive.”
Whether an Exposure is hedged or not, it is assumed that the decision to hedge/ not to
hedge is backed by a View or Forecast, whether implicit or explicit. As such, Stop Loss is
nothing but a commitment to reverse a decision when the view is proven to be wrong.
Suggestions:
Stop Losses should be activated when
• Critical levels in the rate being monitored are reached, which clearly tell that the
view held has been proven wrong.
• The factors/ assumptions behind a view either change or are proven wrong.
• The Exposure Manager should be accorded flexibility to set appropriate Stop-
Losses for each trade.
• The Exposure Manager should, however, make sure he has set a stop-loss for
positions he enters into, on an a priori basis.
While Benchmarks will be based upon the Big Trend and will incorporate a certain
amount of room for error, the Exposure Manager should be careful to not violate the
Benchmark on the wrong side.
1.75 Reporting and Review
There needs to be continuous monitoring whether the Exposures are headed where they
are intended to reach. As such, the Exposure Management activities need to be reported
and reviewed.
Reporting
The Exposure Manager will prepare the following Reports on a regular basis:
Report Name What it shows Periodicity

MTM Report The Mark-to-Market Profit/ Loss status on Open Forward Contracts
Daily, closing
Exposure NAV Report The All-in-all exchange/ interest rate achieved on each
Exposure, and profitability vis-à-vis the Benchmark Fortnightly
VAR Report Expected changes in overall Exposure due to forecasted exchange/ interest
rate movements Monthly
Review
A monthly Review meeting will consider the following:
Issue On the basis of Points to be reviewed
Exposure Performance Exposure NAV Report Is the Benchmark being met/
bettered?
What are the chances of the Benchmark being violated on the wrong side?
Reasons for the Benchmark being violated on the wrong side
Market Situation Reviews of market developments
Forecasts of market movements
Is the Big Trend still in place? Or has it changed?

Benchmarking The above two Does the Benchmark need to be changed?
Hedging Strategy MTM and Exposure NAV Reports Is the strategy working well?
Or does it need to be fine-tuned/ overhauled?
Operational issues Exposure Manager's experiences Operational problems to be
solved
1.76 Conclusion
Exposure Management is an essential part of business and should be viewed with
Objectivity. It is neither a license to print money nor is it a cause for getting trapped in a
Fear Psychosis, and should be viewed with the same clarity of vision as, say, Production
or Marketing is viewed.
Having said that, it should be remembered that
o All that has been stated above cannot start happening straightaway
o Installing Hedging, Reporting and Review systems that work takes time and effort
o There will be a Learning Curve to be overcome when setting Benchmarks
o There will be initial losses, which should be viewed as what they are - initial
losses.
There has to be a long-term commitment to Exposure Management, because it is today an
activity, which no company can afford to ignore.
LATEST IN FOREIGN EXCHANGE - TECHNOLOGY ADVANTAGE
K mailer on :
Finance Published : 31-10-2001 ISSN 0972-3900
International Finance
Online Foreign Exchange - Promises Galore (Update)-- Asian markets have been slow to
adapt to online foreign exchange (fx) trading despite the creation of many private
networks. The promises envisaged prior to the launch still elude the online segment...
Dealing Online (Advance) -- Atriax has been the latest addition to sites that facilitate
foreign exchange (fx) dealings online. However, despite the growing number of sites,
experts are still skeptical about the liquidity they can provide in comparison to physical
markets....
Asian markets have been slow to adapt to online foreign exchange (fx) trading despite the
creation of many private networks. The promises envisaged prior to the launch still elude
the online segment
A year ago, corporate treasurers in Asia were upbeat about the introduction of online fx
trading. In fact many big banks have expressed their desire to start online fx trade.
Experts opined that 25 to 30% of fx transactions would be done online. These
expectations came about when people had a fascination for anything related to the
Internet. Players in fx market felt that online trading would remove the chaos prevalent in
the markets. Online trade was expected to provide liquidity to players trading in global
currencies and also fetch them the best price.
Dreams - unrealised
CFOWeb.com, one of the first Internet forex services set up in 1999, received a dismal
response. According to rough estimates only 2% of the trade in Asia is being done online.
The major reason for this, according to Peter Wong, convenor of the Association of
Corporate Treasurers, is that many of them are still not comfortable with online trade.
They prefer to trade through dealers who can help them in making decisions.
The results of CFO Asia poll, conducted for top 10 corporate treasuries at major
companies in Asia, shows disappointing results. None of them adopted online trade and
only three of them propose to adopt it over the next few years. This is far from what was
predicted. Vendors on their part are not disappointed. They feel that it is too early to
expect huge numbers. For instance, managing director of Cognotec Asia Pacific, an
Internet fx technology provider, feels that treasurers in Japan have just started and those
in Singapore and Honk Kong are yet to start.
The low response, it is alleged is because of banks' resistance to trade on the Internet.
Banks resist transparency with a fear that it might reduce their spreads and hence, their
trading profits. If banks do not adapt to online trade, then their competitors would. Fxall
and Atriax have emerged to take a share of $3 trillion per day fx market. The former has
Bank of America, Credit Suisse First Boston, Goldman Sachs, HSBC, JP Morgan Stanley
Dean Witter and UBS Warburg as its partners. The later has Chase Manhatan,Citibank
and Deustche Bank as partners. Apart from these mega portals many small ones are
emerging. Matchbook FX, Gain Capital, and Currenex are some of them.
Private portals
Despite the growing number of facilitators for online trade, corporates are slow in taking
advantage of them. The basic drawback, from corporates' perspective, of private portals is
that they lack Straight Through Processing (STP). STP means complete automation from
transaction to settlement. This would enhance the speed of processing at a lesser cost and
lesser number of errors. Though Atriax and FXall provide STP, the challenge is to
integrate these with corporates' banks end systems.
Integrating corporates' systems with those of banks would take more time and involve
higher costs. Also the present systems coroprates use are time tested and suffice their
needs. Hence, they consider it is an unnecessary investment at this juncture.
Speed is slow
Online trade requires better connectivity that would enable faster processing of
transactions. However, connectivity in Asia is inconsistent and the processing pace is
phenomenally slow. Private networks have leased lines and hence enhance the speed.
Also, security controls provided by these networks are unmatchable.However these
services are more expensive than traditional channels.
Another cause of concern has been legal issues, which take a long time to be solved. For
instance, when banks give a draft contract to their clients, the initial reaction of clients is
that it is biased towards ISPs. On the other hand, banks restrict their liability in case
systems crash mid way through a transaction. Clients do not like this. Such issues have to
be solved as and when they arise as they are not always predictable.
To conclude...
Despite these hurdles, efforts are on to make online fx trade a success. It, however, goes
beyond saying that banks should take a first step so others follow.
Atriax has been the latest addition to sites that facilitate foreign exchange (fx) dealings
online. However, despite the growing number of sites, experts are still skeptical about the
liquidity they can provide in comparison to physical markets
Atriax, Currenex, FXall and FX connect are sites that have been launched to facilitate
clients' buying foreign exchange (fx). Availability of options will enable clients to
compare functionality offered by them, the products they offer and pricing mechanisms.
Such comparison will help customers to select the right site. Despite the convenience
they offer, customers have been slow to adapt this route. Also these sites are yet to
provide their ability to provide liquidity.
These sites need to adopt existing models in the interbank market and focus on attracting
customers from physical markets.
Reuters and EBS - old war horses

Interbank market started electronic broking in early 1990s, through Reuters and
Electronic Broking Services (EBS). This system uses the matching concept. Under the
system, offers and bids are taken from the clients and a counter party expecting the same
rates is found. Bank to client (b-to-c) platforms, on the other hand, offer a new kind of
mechanism known as request for quote. Under this mechanism, parties to trade decide on
the price, before executing the transaction. This reduces the parties' vulnerability to risk
and hence makes it a preferable channel in comparison to other Internet sites.
b-to-c platforms are basically private networks. However, they are quicker and offer
better security than other channels. Hence, they are more expensive. This should not be a
handicap as they have the ability to cater to interbank (b-to-b) trading models. Also they
offer flexibility to customers in terms of choosing between quote to order and matching
mechanisms. In addition, they claim to introduce new pricing mechanisms in the future.
Atriax facilitates any customer who wants to trade inclusive of b-to-b.
Slow progress
b-to-c platforms are targeting buy side users (people who buy fx products). These people,
however, are not interested in trading complex fx instruments. A majority of them are
still not comfortable with electronic trading. Interbank markets will benefit from b-to-c
channels, which are considered to be a one -stop shop for a diverse range of products.
Atriax and FX all launched by consortium of banks would benefit the most as they can
corner a bigger share of b-to-b market.
b-to-c platforms are now gearing up to the challenges of straight through processing
(STP) that is essential for interbank markets. Also these private networks enable
customers to have automatic download of deals. Since counter parties trade together,
credit checks would become less labour intensive.
Banks oppose opening of markets

It is logical for b-to-c platforms to focus on interbank trade till buy side customers adapt
to it. However, experts opine that these two markets will remain separated. Buy side
customers had a bitter experience in the past while working on interbank fx platforms.
Banks resisted opening up the markets. The same would continue if buy side segment and
inter bank markets remain separated.
B-to-C platforms claim to provide transparency about the pricing they offer. This might
be misleading as customers can make a comparison between prices banks are offering but
still they cannot know the interbank pricing. This would mean that big banks would still
command prices in the market. These b-to-c platforms offer an ideal situation for banks
for the following reasons:
• When b-to-c and b-to-b markets remain separated, banks need not declare their
tightest prices, in a b-to-c environment where anybody can trade with anybody
• As long as markets are separate banks would be protected from the threat of
disinter mediation and the possibility of developing buy-side to buy-side credit
relationships
• In request for quote markets big banks have an undue advantage of winning
clients of small banks
The cumulative affect of all this will hinder the efficiency of markets. b-to-c platforms
designed to remove intermediation will not be able to achieve this and banks will
continue to get their margins by acting as intermediaries.
RESREVE BANK OF INDIA REGULATIONS & DEFINITIONS

1.77 Short title & commencement
1. These Regulations may be called the Foreign Exchange Management (Foreign

exchange derivative contracts) Regulations, 2000.
2. They shall come in force on the 1st day of June 2000.
1.78 Definitions
In these Regulations, unless the context requires otherwise, -
(i) Àct' means the Foreign Exchange Management Act,1999 (42 of 1999);
(ii) àuthorised dealer' means a person authorised as authorised dealer under sub- section
(1) of section 10 of the Act;
(iii) `Cash delivery ' means delivery of foreign exchange on the day of transaction ;
(iv) `Forward contract' means a transaction involving delivery, other than Cash or Tom or
Spot delivery, of foreign exchange;
(v) `Foreign exchange derivative contract' means a financial transaction or an

arrangement in whatever form and by whatever name called, whose value is derived from
price movement in one or more underlying assets, and includes,
(a) a transaction which involves at least one foreign

currency other than currency of Nepal or Bhutan, or
(b) a transaction which involves at least one interest rate applicable to a foreign
currency not being a currency of Nepal or Bhutan , or
(c) a forward contract, but does not include foreign exchange transaction for Cash or Tom
or Spot deliveries;
(vi) `Registered Foreign Institutional Investor (FII) ' means a foreign institutional investor
registered with Securities and Exchange board of India;
(vii) `Schedule' means a schedule annexed to these RegulationS;
(viii) `Spot delivery' means delivery of foreign exchange on the second working day after
the day of transaction;
(ix) `Tom delivery' means delivery of foreign exchange on a working day next to the
day of transaction;
(x) The words and expressions used but not defined in these Regulations shall have the
same meanings respectively assigned to them in the Act.
1.79 Summary of Exchange Rate Regime in India
• Foreign exchange for all permitted imports, payment of dividend, interest on

approved ECBs is freely available.
• For other current account purposes like travel, study abroad, hiring foreign
personnel, specific exchange control guidelines.
• All receipts from exports / remittances / income must be sold to AD at prevailing
rate. A part of the earnings can be kept in the form of foreign currency for specified time
period and this balance can be used for specified purpose.
• Capital account transactions are subject to exchange controls. These include
borrowing abroad, acquisition of assets abroad, JV contribution, etc.
• Corporates can maintain foreign currency accounts abroad subject to approval by
RBI.
1.80 Exchange Rate Calculations
• Cash or ready delivery means delivery on the same date.

• Value next day means delivery on the next business day.
• SPOT means two business days ahead.
• For Forward contracts, the delivery date is either fixed in which case the tenor is
computed from the SPOT value date or it may be option Forward in which case the
delivery may be during a specified week or fortnight.
• Rates quoted by banks to non-banking customers are called Merchant Rates.
• TT Rate denotes rate applicable for clean inward or outward remittance i.e. the
bank undertake from the currency transfer and does not perform any other function such
as handling documents.
• When there is delay between bank paying the customer and bank itself getting
paid (bank discounting export bill), the bank may charge margin from the TT buying rate.
The margins are subject to ceiling specified by FEDAI.
• Similarly on the selling side when bank has to handle documents, apart from
effecting payment, margins are added to TT selling rate.
1.81 Multi Currency Option
• This enables the borrower to change the borrowed currency on any interest
refixation day based on short-term view on likely movements in the exchange rates.
• The loan document may provide for this option. It would prescribe the primary
currency (usually Dollar) and alternate currencies.
• Switch from primary to alternate currency is allowed on any roll over day.
Conversion done at SPOT rate ruling on the roll over day.
• If interest linked to LIBOR, the new interest is based on LIBOR applicable to the
alternate currency.
• On the next roll over day, borrower has option to continue in alternate currency,
switch back to primary currency or switch to another alternate currency.
• Liability of the borrower is calculated in primary currency.
FROM THE ILLUSTRATION - Lessons to be Learnt
? If borrower's view on the likely movement in exchange rate goes wrong, he can
incur substantial repayment liability.
? Borrower has to constantly monitor the exchange market and cover the exchange
risk at appropriate point during the roll over by purchasing Swiss Franks in the forward
market.
? Multi currency option does not require him to take a long term view on the
currency borrowed but can limit the risk by taking a series of short term views.
? Lending bank has no difficulty in allowing multi currency option since it funds
the loan through short-term borrowing.
INFORMATION ON EURO
1.82 Evolution of Euro market
a. Russians (Ironical) originated - sale of gold and other commodities and buying
grain. Parking of funds in Euro instead of US.
b. Restrictions imposed by US authorities on domestic banks and capital markets -
ceiling on deposit interest, CRR, Deposit Insurance.
c. Dollar being vehicle currency, many European corporations have cash flows in
Dollars and hence surpluses / deficits.
1.83 What are Euro markets?
a. It is mainly an inter-bank market trading in time deposits and debt instruments. A

Euro currency deposit is a deposit in the relevant currency with a bank outside the home
country of that currency. For e.g. US Dollar Deposit in London Bank is a Euro Dollar
Deposit or a DM Deposit in Parris is Euro Mark Deposit.
b. Similarly a Euro Dollar Loan is a Dollar Loan made by bank outside the US to a
customer / another bank.
c. The prefix Euro is now outdated since such deposits / loans are often traded
outside Europe, like Singapore and Hong Kong.
Instruments
• Certificates of Deposit (CD) - Short-Term Instrument

• Euro Commercial Paper (ECP) - Short-Term Instrument
• Medium to Long-Term Floating Rate Loans
• Floating Rate Notes
Why such instruments are so attractive?
• Euro banks are free from regulatory provisions like CRR, Deposit Insurance, etc.
• This results in reduced cost of funds.
• Lesser restrictions on "rating" and disclosure requirements applicable for
domestic issues and registrations with security exchange authorities.
Interest Rates
a. In the Euro currency market, Inter-bank borrowing and lending rates are
benchmarked by LIBOR.
b. LIBOR is index of rate charged by one first class bank in London to another first
class bank for a short-term loan. It is not necessarily rate charged by a particular bank
but it is an indicator of demand supply condition in the inter-bank deposit market in
London.
c. Three and Six months LIBORs are normally available. A Euro currency deposits
range in maturity from overnight to one year.
d. LIBOR varies according to the currency and the term.
FOREX MARKET IN INDIA
• India - founder member of IMF

• Fixed Exchange Rate System - Intervention currency was Pound.
• Post 1971, RBI continued to maintain parity with Pound and crossed
currency rates determined through parity with Pound.
• September 1975 - Trade substantially diversified in terms of currencies.
Hence, Rupee linked to a secret basket. Pound continued to intervention currency.
• July 1991 major devaluation of Rupee, intervention currency changed to
dollar and cash compensatory support for exports discontinued.
• March 1992: LERMS - Duel Exchange Rate System 60:40.
• March 1993: Single market determined rate.
• Spot and forward rates determined by demand and supply.
• Direct Rate: Exchange rate for a foreign currency expressed in terms of
units of local currency equal to one unit of foreign currency for e.g. US $ 1.00 = INR
47.05.
• Indirect Rates US $ 2.3529 = INR 100.00.
• Buying Rate and selling rate are also referred as bid and offered rates.
• Spot Rate = Rate used for immediate transaction for a particular time.
• Tomorrow value (TOM) for next working day.
• Forward Rate = Rate quoted for transaction over a period of time in case
of transactions that takes place at a future date.
Local Exchange Market is two tier
1. Non-bank customers who buy / sell currency from authorized dealers.

2. Interbank market.
• RBI can influence the market rates through:
1. Verbal (media statements).

2. Tightening exchange control to curb speculation.
3. Tightening money supply or change of interest rates.
4. Actual sale or purchase of dollars.
Global Financial Market
• Emergence of global markets since mid 70's. Massive cross border capital flows.
• Euro currencies market: Borrower / investor from country A could raise / place
funds from / with financial institutions located in country B, denominated in the currency
of country C.
• This market performed useful function of recycling "Petro-Dollars" beyond 1973
oil shock. It is no more a "Euro" market but a part of "offshore market".
• Liberalization and removal of restrictions in developed and developing countries
has accelerated geographical integration of financial markets.
• Early 80's: Process of disinter mediation where in highly rated issuers began
approaching investors directly rather than going through bank loan route.
• Intense competition amongst commercial banks, lower spreads in domestic
operations and hence need for additional products and markets.
• Need for external financial assistance from developing countries due to
disequilibrium in BOP.
• Extent of linkage (cost of funding) between domestic and offshore markets
depends on extent of regulation in the domestic and offshore markets.
Bibliography & List of References
I. Primary Sources of Data

(Interview conducted with the following personnel from the Company):
Mr. Suresh Bagul, M/s Ciba Specialty Chemicals India Limited
Mr. Mahesh Kalmane, M/s Ciba Specialty Chemicals India Limited
II. Secondary Sources of Data

A. The Internet
Economic Times Website

The Business Standard Website
Reserve Bank of India Website
ICAI Website
Giddy's Web Portal (ian.giddy@nyu.edu)
The Managementor.Com website
B. Print Media
Annual Report 2000-2001: M/s Ciba Specialty Chemicals India Ltd.

International Financial Management-P.G.APTE

The Economic Times
Business Standard
RBI Circulars
The Management of Foreign Exchange Risk
- Ian H. Giddy & Gunter Dufey, New York
University and University of Michigan)
Foreign Exchange Handbook
-H.P. Bharadwaj
Multinational Financial Management
- Alan C. Shapiro
Options, Futures & other Derivatives
- John C. Hull
"Translation Methods and Operational Foreign Exchange Risk Management,"

- Alder, Michael

Forex Exposure Management

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RUDIMENTS OF FOREIGN EXCHANGE 7

OVERVIEW OF FOREIGN TRADE 15

ORGANISATIONAL SET UP OF M/S CIBA SPECIALTY CHEMICALS INDIA LTD

FOREX MANAGEMENT POLICY 20

GUIDELINES FOR RISK MANAGEMENT 40

VALUATIONS OF FOREIGN EXCHANGE EXPOSURES 42

THE MANAGEMENT OF FOREIGN EXCHANGE RISK 49

FOREIGN EXCHANGE MARKET 73

LATEST IN FOREIGN EXCHANGE - TECHNOLOGY ADVANTAGE 91

RESREVE BANK OF INDIA REGULATIONS & DEFINITIONS 95

FROM THE ILLUSTRATION - LESSONS TO BE LEARNT 98

FOREX MARKET IN INDIA 101

BIBLIOGRAPHY & LIST OF REFERENCES 103

RUDIMENTS OF FOREIGN EXCHANGE

1.1 Foreign Exchange-Introduction

Def: Sec 2(b) of Foreign Exchange Regulation Act, 1973 states:

“Foreign Exchange” means foreign currency and includes:

1.2 The need for Foreign Exchange

1.4 Foreign Exchange Market

Foreign Exchange market is in fact misnomer or misleading in as much as there is no

Commercial banks dealing with international transactions offer services for

• Exchange rate Management

1.6 Types of dealing in the local Foreign Exchange Markets

• Transaction between Banks and RBI

After introduction of Modified Liberalized Exchange Rate Management System

1.7 Factors that contribute to the growth of Indian Forex Markets

Better communication network like telephones, telexes, SWIFT, Reuters/Telerate system

• Types of currencies traded in Indian Market

• Growth of forex market over the years

• FEDAI's role in the forex market

• Authorised dealers in foreign exchange

• Rupee quoted against Dollar

• Activities that can possibly carry foreign exchange exposure

OVERVIEW OF FOREIGN TRADE

The opening of specialised FX desk in branches, the proliferation of dedicated overseas

ORGANISATIONAL SET UP OF M/S CIBA SPECIALTY CHEMICALS INDIA LTD

1. Imported Raw Materials & Capital Goods

IMPORTS OF CSCIL IN THE LAST 5 YEARS

Year 95-96 96-97 97-98 98-99 99-00

EXPORTS OF CSCIL IN THE LAST 5 YEARS

Year 95-96 96-97 97-98 98-99 99-00

• Forex Management Policy

FOREX MANAGEMENT POLICY

It is said that whatever gets measured gets managed better.

DEPT/ACTIVITY DEPT/ACTIVITY EXPOSURE RESULT

Variable / Cash Flows Transaction Type

? Foreign Currency Cash Flows/ Schedules

1.12 Concept of Gross Exposure and Net Exposure

There are certain limitations of looking at Net Exposures:

• The period of inflow and outflow may not match;

A slightly different but more practical approach to this is shown below:

a) Operational or Treasury Department Level:

b) Top management level

The answer is Yes. We will see this in our next section.

1.14 Performance Evaluation Criteria

• One major problem is that of a having reasonable and rational performance

Consider following factors:

2. Forex market has rarely responded to basic fundamental factors in short to

1.15 Foreign Exchange Risk Management Policy of M/s CSCIL

The primary components of the risk management process are:

• A comprehensive risk management approach

Responsibility for daily currency risk management activities is concentrated in a central