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FOREIGN EXCHANGE RISK MANAGEMENT
date]
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Objective

This paper seeks to examine the various kinds of risks which can be faced by companies which
are dealing with cross-border transactions (either exporting or importing items in another
currency). It then goes on to describe the instruments available to companies to hedge such risks.
These companies may use natural hedging or use instruments like Currency forwards, options
and futures. Finally, it gives an overview of the derivative market in the world and compares it
with the Indian market.

Executive Summary
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Classification of Foreign Exchange Exposure and Risk

The figure below presents a schematic picture of currency picture. In the short term, the firm is
faced with two kinds of exposures.

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Types of Risks

1. Translation Exposure

Translation (or balance sheet) exposure can be defined a s a risk that, when translated at
the foreign exchange rates which will apply at a future balance sheet date, the domestic
( or base) currency values. A firm may have assets and liabilities denominated in a
foreign currency. These are not going to be liquidated in the near future but accounting
standards which govern the reporting and disclosure practices require that at the end of
the fiscal year, the firm must translate the values of these foreign currency denominated
items into its home currency, and report them in the balance sheet.
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Translation exposure typically arises when a parent multinational company is required to

consolidate a foreign subsidiary’s statements with the company’s own statements after
translating the subsidiary’s statement s from its functional currency into the home
currency.

Example: Suppose an Indian company has a UK subsidiary. At the beginning of the

parent’s financial year, the subsidiary has real estate, inventories and cash valued at £
10,00,000, £ 2,00,000 and £ 150,000 respectively . The spot rate is Rs 80 per pound. By
the close of the financial year, these have changed to £ 9,50,000 , £ 2,05,000 and £
160,000. However there has been a drastic depreciation of the pound to Rs 75. The parent
is required to translate the balance sheet from pound to Rupee at the current exchange
rate, it has suffered a translation loss. The translated value of its assets has declined from
Rs 10.80 Crores to Rs 9.8625 Crores.

2. Transaction Exposure

An unanticipated change in the exchange rate has an impact- favourable or adverse- on

its cash flows. Such Exposures are known as transaction exposures. In essence it is a
measure of the sensitivity of the home currency value of assets and liabilities which are
denominated in a foreign currency, to unanticipated changes in exchange rates, when
assets and liabilities are liquidated. The foreign currency values of these items are
contractually fixed i.e. do not vary with exchange rate. Hence it is also known as
contractual exposure.

Some typical situations which give rise to transaction exposure are:

o A currency has to be converted in order to make or receive payment for goods and
services – import payable or export receivables denominated in a foreign
currency.

o A currency has to be converted to repay a foreign currency loan or make an

interest payment on the loan
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o A currency has to be converted to make dividend , royalty payment etc.

Example of transaction exposure

A typical example of transaction exposure can be a company which incurs its costs in Rs
and buys components which are priced in Dollars. The rate at which the company can
purchase its Dollar payables against Rupee will determine the level of profit it makes. If
the Rupee strengthens against the Dollar, it will incur a loss.

The key difference between transaction and translation exposure is that the former has an
impact on cash flows while the latter has no effect on cash flows.

3. Economic Exposure

Economic Exposure arises in a number of ways, each of which derives from the position of a
company in relation to its competitors. Economic exposure may be direct and indirect, as
shown by the following example

Direct Exposure

An Indian company exports to the US and prices in Dollars. It is competing against American
companies, who also have costs in Dollars. The Indian company has costs in Rupees and will
suffer a competitive disadvantage if the dollar depreciates.

Indirect Exposure

For example, a Indian company is exporting to the US and is in competition with another US
company. It hedges its foreign currency receipts into Rupees to guard against Forex risk. Its
competitor has not done so, because it expects the Rupee to weaken. If the rupee does
weaken, then the competitor will be at an advantage.
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Risks in the foreign exchange market

 MARKET OR PRICE RISK: - The risk arising out of open currency positions are easy to
understand. If one is overbought and the currency weakens, one would be able to square
the overbought position only by selling the currency at a loss the same would be the
position if one is oversold and the currency hardens. Given magnitude of exchange
fluctuations witnessed in recent years, the possibilities of substantial losses can hardly be
overlooked.
 CREDIT RISK: - Credit risks are also very important in foreign exchange and derivatives
transactions. These can arise when a counterparty, whether a customer or a bank, fails to
meet his obligation and the resulting open position has to be covered at the going rate. If
the rates have moved against you, a loss can result.
 OPERATION RISK: - A loss can also occur because of human error, fraud or lack of
effective internal controls. The bank office which handles contract exchanges,
settlements, reporting, etc. has to be completely independent of the front office which
does the deals in the market.
 LEGAL RISK: - This arises from the legal enforceability of contracts. The question of the
legality of netting all outstanding transactions with failed counter party has been touched
upon earlier.
 LIQUIDITY RISK: - This is arises when, for whatever reason, markets turn illiquid and
positions cannot be liquidated except at a huge price concession.
 SETTLEMENT RISK: - This is the risk of counterparty failure during settlement, because
of time differences in the markets in which cash flows in the two currencies have to be
paid and received. Many banks suffer losses in the Herstatt bank failure when marks had
been paid out in Frankfurt, but before dollar could be received in New York the bank
closed. Since then, many banks impose a settlement limit on counterparties for aggregate
settlements on any value date.
 SYSTEMIC RISK: - This is the possibility of a major bank failing and the resultant losses
to counterparties reverberating in to a banking crisis worldwide. There is little that any
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individual bank can do about this problem, which is a specter haunting supervisory
authorities in major money markets. The Basle committee proposals

How to Mitigate Risk

Internal Hedging

It is the process by which an organization minimizes the amount of currency that it will eventually
need to buy or sell in foreign exchange transactions with banks. There are three main ways by
which this can be achieved.

1. Through pricing actions

If exposed to foreign exchange risk, the company can enter into forward contracts.

2. Leading and Lagging

This is carried out at the time of receipts and payments. Leading means making payments
early, while lagging means making payments late. Where the base currency is weak, the
company would seek to lead its foreign currency payments and lag its foreign currency
receipts. Where the base currency is strong, it would take the opposite approach.

3. Netting
The purpose of netting is to enable currency exposures to be both clearly identified and
managed in the most efficient way. This means, hedging exposure by means of the fewest
transactions, and as far as possible, in the most marketable amounts. Netting, therefore
involves the elimination of both buying and selling the same currency and the aggregation of
each currency in which there is a net exposure into the largest possible amount.
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Forex Hedging Instruments

Forward contract

The main use of a forward contract is to hedge actual and forecast currency exposures that would
crystallize at a later date. Through the use of a forward contract, the company can fix an exchange
rate today for the conversion of a future currency receipt or payment.

Example

Suppose an Indian company exports auto components to the USA. It has a negative view on the
Dollar and believes the Dollar will depreciate in the short term. The current Rs/$ exchange rate is Rs
45 per Dollar. The company thus enters into forward contract to sell the Dollar at a pre-fixed rate
suppose Rs 46 3 months in the future. Thus, if the company is betting right on the exchange
movement and the Rupee appreciates to Rs 42 after 3 months, it can sell the Dollar at the agreed
price and hedge itself against currency risk.

Currency Futures

The idea behind currency futures is very simple. If the corporation has an asset e.g. a receivable in
currency A which it would like to hedge, it should take a futures position such that the futures
generate a positive cash flow whenever the asset declines in value. In this case, since the firm is long
on the underlying asset, it should go short on the futures position.

Example:

A British company orders some raw materials in September from a US supplier for delivery and
payment in 3 months time. The cost of materials is $ 450,000. The company could simply buy the
Dollars at the current forward rate of £ 1= $1.50 but instead chooses to hedge using futures.

It sells 12 £25000 sterling contracts for December delivery at the market rate of $1.50= £1.

By December, the spot rate has moved to $ 1.40- £1. The effect of that the company benefits on the
rate.

Currency Options
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Investors use currency Future contracts to hedge against foreign exchange risks. If an investor is
going to receive a cash flow denominated in foreign currency on some future date, the investor can
lock into the current rate by entering into an offsetting position that expires on the day of the cash
flow

Example:

Suppose an importer wants to import goods worth $ 100, 000 and places his order on September 1,
2009 with the delivery date being 3 months ahead. At the time of ordering, $ 1- Rs 47 in spot
market. But, if the rupee depreciates o Rs 48.30 when the contract expires in December, the value of
payment goes up to Rs 48,30,000. The company pay 5 paise as premium per option. So it pays Rs
47,05,000, thus netting a profit of 25000.

Graph

Interest rate Swaps

Currency Swaps

Indian Scenario

Some Products which are present in the derivative market in India are :
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1. Foreign Exchange Forwards- These are used to hedge crystallized foreign currency foreign
interest rate exposure and to transform exposure in one currency to another permitted currency.

2. Foreign Currency Rupee Swap- This is used to hedge or transform exposure in foreign
currency / foreign interest rate to rupee / rupee interest rate

3. Cross Currency options- To hedge or transform foreign currency exposure arising out of
current account transactions

4. Foreign Currency Rupee Options

Customers of market-makers who have genuine foreign currency

5. Other Products
For certain specific purposes, RBI has permitted the use of cross currency swaps, caps and
collars and FRAs. For example, entities with borrowings in foreign currency under ECB are
permitted to use cross currency swaps, caps and collars and FRA for transformation of and/or
hedging foreign currency and interest rate risks. These three products can be offered only for the
purposes specified by RBI and not otherwise. Use of any of these products in a structured
product not conforming to the specific purposes is not permitted. In respect of foreign exchange
derivatives, market participants may be guided by the instructions issued by Foreign Exchange
Department, RBI from time to time to the extent indicated in these guidelines.

Global Trends

The growth of these markets, both OTC and exchange traded has been phenomenal. The
highlights of the latest available BIS Triennial Central Bank Survey of Foreign exchange and
derivatives market activity December 2007, with respect to activity on the OTC and exchange
traded currency derivatives markets are:
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 The total daily average turnover in foreign exchange OTC markets for the month of
April, 2007 was USD 2.3 trillion as against USD 1.3 trillion in April, 2004. In
comparison, the figure for exchange traded currency contracts was USD 72 billion in
April 2007 and USD 22 billion in April, 2004

 Activity in the foreign exchange segment of the OTC derivatives market continued to be
dominated by traditional instruments such as outright forwards and FX swaps with an
average daily turnover of USD 2.1 trillion, these instruments accounted for 90% of
turnover in FX derivatives, virtually unchanged from 2004. Among the non-traditional,
more complex, products, turnover in currency options increased by 81% to USD 0.2
trillion, or 9% of the total FX segment. Volumes of currency swaps increased by 49% to
USD 0.03 trillion
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Indian Derivatives market

The economic entities in India have a menu of OTC currency products to use, such as forwards,
swaps and options, for hedging their currency risk. In respect of forex derivatives involving
rupee, residents have access to foreign exchange forward contracts, foreign currency-rupee
swap instruments and currency options - both cross currency as well as foreign
currency-rupee. In the case of derivatives involving only foreign currency, a range of products
such as IRS, FRAs, option are allowed. While these products can be used for a variety of
purposes, the fundamental requirement is the existence of an underlying exposure to foreign
exchange risk whether on current or capital account. During the period 1975-1992, the exchange
rate of Rupee was officially determined by the RBI in terms of a weighted basket of currencies
of India's major trading partners and there were significant restrictions on the current account
transactions. As a result, the forex markets witnessed limited activity over this period. It was
only after the floating of the currency in March 1993, following the recommendations of the
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Report of the High Level Committee on Balance of Payments (Chairman: Dr. C. Rangarajan),
that these markets saw an increase in activity.

The appointment of an Expert Group on Foreign (popularly known as Sodhani Committee) in

November 1994 is a landmark in the design of foreign exchange market in India. The Group
studied the market in great detail and came up with far reaching recommendations to develop,
deepen and widen the forex market. Some of the main recommendations of the Committee were
that banks may be permitted to initiate cross currency positions overseas; they may be permitted
to borrow and lend in overseas markets; the number of market participants should be increased
by permitting financial institutions like IDBI, IFCI etc.; market intervention by RBI should be
selective rather than continuous; corporates should be allowed to hedge upon declaration of the
underlying etc. Most of these recommendations have been accepted and implemented in the
process of development of forex markets. Tarapore Committee on Capital Account
Convertibility of 1997 also recommended a number of measures relating to financial markets,
especially forex markets. Some important developments in the policy framework for these
markets over time based on the recommendations of these committees and otherwise, have been:

 Banks have been allowed freedom to fix their trading limits, permitted to borrow and
invest funds in the overseas markets up to specified limits. They can now determine
interest rates on FCNR deposits within ceilings and can use derivative products for asset
liability management purposes.

 Corporates have been given flexibility to use a variety of instruments like interest rates
and currency swaps, caps/collars and forward rate agreements in the international forex
market.

 While initially the forward contracts could not be rebooked once cancelled, greater
flexibility has now been given for booking cancellation and rebooking of forward
contracts.
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 Exporters and importers are also allowed to book forward contracts based on past
performance and the delivery condition has also been gradually liberalized.

 In order to simplify procedural requirements for Small and Medium Enterprises (SME)
sector, RBI has granted flexibility for hedging underlying as well as anticipated and
economic exposures without going through the rigours of complex documentation
formalities. In order to ensure that SMEs understand the risks of these products, only
banks with whom they have credit relationship are allowed to offer such facilities. These
facilities should also have some relationship with the turnover of the entity

 .Individuals have been permitted to hedge up to USD 100,000 on self declaration basis.

 Authorized Dealer (AD) banks can also enter into forward contracts with residents in
respect of transactions denominated in foreign currency but settled in Indian Rupees
including hedging the currency indexed exposure of importers in respect of customs duty
payable on imports.

 Foreign Institutional Investors (FII), persons resident outside India having Foreign Direct
Investment (FDI) in India and Non-resident Indians (NRI) are allowed access to the
forwards market to the extent of their exposure in the cash market. FIIs are permitted to
hedge currency risk on the market value of entire investment in equity and/or debt in
India as on a particular date using forwards. For FDI investors, forwards are permitted to
hedge exchange rate rise on the market value of investments made in India since January
1, 1993; hedge exchange rate risk on dividend receivable on the investments in Indian
companies and hedge exchange rate risk on proposed investment in India. NRIs can
hedge balances/amounts in NRE accounts using forwards and FCNR (B) accounts using
rupee forwards as well as cross currency forwards.

The gross turnover in the OTC derivatives (swaps and forwards) segment of currency markets
has been steadily increasing over time with activity picking up particularly in late 2007 and
through 2008, following the increased volatility in USD-INR exchange rate. The average daily
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turnover, calculated on a monthly basis, reached an all time high of USD 35 bn in September,
2008. The year 2008 closed with average daily volumes of USD 28.63 bn in these markets
over the full year.

OTC annual turnover bn$

9000
8000
7000
6000
5000
4000
3000
2000
1000
0
2005-06 2006-07 2007-08 2008-09
.

daily turnover
35

30

25

20 daily turnover

15

10

0
2005-06 2006-07 2007-08 2008-09
.

Exchange traded Currency Futures

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India's financial market has been increasingly integrating with rest of the world through
increased trade and finance activity, as noted above, giving rise to a need to permit further
hedging instruments, other that OTC products, to manage exchange risk like currency futures.
With electronic trading and efficient risk management systems, exchange traded currency futures
were expected to benefit the universe of participants including corporates and individual
investors.

The RBI Committee on Fuller Capital Account Convertibility recommended that currency
futures may be introduced subject to risks being contained through proper trading mechanism,
structure of contracts and regulatory environment. Accordingly, Reserve Bank of India in the
Annual Policy Statement for the Year 2007-08 proposed to set up a Working Group on Currency
Futures to study the international experience and suggest a suitable framework to operationalise
the proposal, in line with the current legal and regulatory framework. This Group submitted its
report in April, 2008. Following this, RBI and Securities and Exchange Board of India (SEBI)
jointly constituted a Standing Technical Committee to inter-alia evolve norms and oversee
implementation of Exchange Traded Currency Derivatives. The Committee submitted its report
on May 29, 2008. This report laid down the framework for the launch of Exchange Traded
Currency Futures in terms of the eligibility norms for existing and new Exchanges and their
Clearing Corporations/Houses, eligibility criteria for members of such Exchanges/Clearing
Corporations/ Houses, product design, risk management measures, surveillance mechanism and
other related issues.

Currency Futures
The Regulatory framework for currency futures trading in the country, as laid down by the
regulators, provide that persons resident in India are permitted to participate in the currency
futures market in India subject to directions contained in the Currency Futures (Reserve Bank)
Directions, 2008, which have come into force with effect from August 6, 2008.

Standardized currency futures have the following features:

a. Only USD-INR contracts are allowed to be traded.
b. The size of each contract shall be USD 1000.
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c. The contracts shall be quoted and settled in Indian Rupees.

d. The maturity of the contracts shall not exceed 12 months.
e. The settlement price shall be the Reserve Bank's reference Rate on the last trading day.

NSE was the first exchange to have received an in-principle approval from SEBI for setting up
currency derivative segment. The exchange lunched its currency futures trading platform on 29th
August, 2008. While BSE commenced trading in currency futures on 1st October, 2008, Multi-
Commodity Exchange of India (MCX) started trading in this product on 7th October, 2008.

156 International Research Journal of Finance and Economics - Issue 2 (2006)

Conclusion