FOREIGN EXCHANGE HEDGING TECHNIQUES USED BY COMPANIES AND GLOBAL FOREX MARKETFACULTY GUIDE: Prof. Arpita Ma’am BY: Piyush Gaur Roll No: 35
CONTENTS:∗ Foreign Exchange Meaning∗ Hedging Strategies∗ Global Foreign Exchange Market∗ USA – China Currency Issue∗ European Deb Crises
Structure of Financial Markets Equity Debt Foreign Exchange Commodities
FOREIGN EXCHANGEForeign exchange is the system or process ofconverting one national currency into another, and oftransferring money from one country to another.
GLOBAL FOREIGN EXCHANGE MARKETForeign Exchange Market is worldwide decentralized OTCFinancial Market for trading of Currencies.∗$1.490 Trillion in spot transactions∗$475 Billion in outright forwards∗$1.765 Trillion in foreign exchange swaps∗$43 Billion currency swaps∗$207 Billion in options and other products
INDIAN FOREIGN EXCHANGE MARKET∗ In India it started in 1978 the government allowed banks to trade foreign exchange with one another.∗ Trading is regulated by the Foreign Exchange Dealers Association of India.∗ Clearing and settlement functions in the foreign exchange market are carried out by the Clearing Corporation of India Ltd.
RANBAXY LABORATORIES∗ In year 2008∗ Company entered into numerous Forex Strip Options.∗ At that time USD-INR was Rs. 39.90.∗ Bought PUT Option from Bank.∗ Sold CALL Option to Banks.∗ Dollar Appreciated.∗ Bank Exercised CALL Options.∗ Rs. 784 Crore Loss.
ANALYSIS∗ Company opted for CALL & PUT option so risk should have been hedged.∗ But the Ratio was 1:2.5CALLS.∗ Loss due to writing off call option & Loss of premium paid.
AXIS BANKLiability on account of outstanding forward exchange and derivative contracts: Rs. In Crores 2010-11 2009-10Forward Contracts 194,049 126,535Interest Rate Swaps, Currency Swaps, Forward 164,701 131,757Rate Agreement &Interest Rate FuturesForeign Currency Options 14,125 5,616TOTAL 372,877 263,909
For Foreign Branches:∗ Assets and liabilities (both monetary and non- monetary as well as contingent liabilities) are translated at closing rates notified by FEDAI at the year end.∗ Income and expenses are translated at the rates prevailing on the date of the transactions.
∗ All resulting exchange differences are accumulated in a separate ‘Foreign Currency Translation Reserve’ till the disposal of the net investments.∗ Premium/discount on currency swaps is recognized as interest income/expense and is amortized on a pro- rata basis over the underlying swap period.∗ Other obligations in foreign currencies are disclosed at closing rates of exchange.
∗ The Bank also undertakes transactions in: ∗ Cross Currency Swaps ∗ Principal Only Swaps ∗ Coupon Only Swaps ∗ Long Term Forex Contracts (LTFX) for hedging its Balance Sheet and also offers them to its customers.∗ Derivatives for market making purpose are marked to market and the resulting gain/loss is recorded in the P & L Account.
BALANCE OF TRADE SURPLUS/DEFICITLOGO Your site here
End of Britton woods∗ By the early 1970s, as the Vietnam War accelerated inflation, the United States was running not just a balance of payments deficit but also a trade deficit.∗ The crucial turning point was 1970, which saw U.S. gold coverage deteriorate from 55% to 22%.∗ In the first six months of 1971, assets for $22 billion fled the United States.∗ In response, on August 15, 1971, President Nixon unilaterally “closed the gold window.”
1988 Omnibus Trade & Competitiveness Act.∗ Act requires the Treasury Department to report on exchange rate policies of Countries which have large Global Current Account Surplus & Trade Surplus with US.∗ The aim was to find out, if they manipulate their currencies against dollar.∗ And if manipulation found than Treasury is required to negotiate & end such practices.
Composition of China’s Foreign Exchange Reserves∗ Remains a secret∗ Expert guess: 70% in U.S. dollars, 20% in Euros, and 10% in Japanese Yen∗ Of U.S. dollar denominated assets, about 70% in treasury bonds and the rest in agency debts (such as Fannie Mae and Freddie Mac)
Chinese perspective∗ USA is managing its currency to keep it form appreciating.∗ Not as overtly as we are, but the US mix of paralyzed fiscal policy & loose monetary policy, will naturally depreciate the dollar.∗ It does so precisely to enable economic growth & some of this would come at the expense of other countries.∗ In doing so it fosters global imbalances & forces a massive flow of funds to the rest of world, potentially stoking the next of bubbles that will eventually burst.
USA Perceptive∗ China is managing its currency to keep it from appreciating.∗ It does so precisely to enable its export sector to flourish at the expense of other countries.∗ In doing so it fosters global imbalances.∗ It helped keep US borrowing rates low, thereby stoking the bubble burst into the global financial crises.
USA – CHINA Currency issue∗ China’s Currency is Undervalued by 40%.∗ Resulted in: Chinese export to US Cheaper & US export to China Expensive∗ Also rise in US Trade Deficit from $ 30bn in 1994 to $ 260bn in 2007.
USA – CHINA Currency issue The large CAD sends billions of dollars abroad, particularly to China. People’s Bank of China uses the inflow of dollars to purchase assets, mostly U.S. Treasuries. Much of the $400 billion fiscal deficit is financed by China. If China stops purchasing U.S. assets and switches to Japan, Europe, or other markets, it will cause a fall in the dollar and long-term interest rates will increase.
USA – CHINA Currency issue∗ China Modified its Currency Policy on July 21, 2005.∗ Yuan’s Exchange rate become adjustable with respect to Market Demand & Supply of currency in Basket.∗ Basket includes Dollar, Euro, & Yen etc.∗ So $ = 8.11 Yuan (2.1% appreciation)∗ Also Yuan can fluctuate by 0.3% on daily basis against basket.
China’s currency reform announced in July 2005∗ China did not fully do what it announced,∗ i.e., basket peg (with Fluctuating RMB +/- .3% band People Bank of China kept RMB very close to the $ in 2005-2006. ∗ Subsequently, some appreciation in 2007-08 ∗ But not against the implicit basket, ∗ only against $, as other currencies in basket (€) appreciated against $
USA – China Currency Issue China has highest foreign currency reserve because of: High amount of Export & Hot money arrival i.e. foreign funds bought into the country. To tackle this the value of RMB should increase. In 2008 Foreign Exchange Regulations approach RMB exchange rate against other fully convertible currencies using floating system, based on Demand & Supply of Foreign Currency.
View from the rest of world∗ China & USA are both actively trying to depreciate their Currencies.∗ In doing so they are prompting a massive wave of funds to search the world for higher returns.∗ While we like the attention, too much of good things has led to problem in past. ∗ Some bad decision will be made. ∗ And might a prolonged surge in capital inflows morph into a abrupt sudden stop.
Way forward∗ US & China should agree that :∗ China is manipulating its currency overtly through its exchange rate policy.∗ US is manipulating its currency through its combination of fiscal, monetary & tax policies.∗ Address the underline forces at work:∗ Both should agree to address some of the underlying forces that are at work.
A way forward - CHINA If China intends to allow a series of small appreciations in the renminbi then it either has to 1. Keep its interest rates below U.S. rates, so that low interest rates offset the expected return from renminbi appreciation over time (currently bank deposit rates in China are capped at 2.5%, below the 3.5% federal funds rate). 2. Intervene a lot. 3. Or do both.∗ It should allow the financial sector to develop ( i.e. end financial repression ) enabling better access to finance.
A way forward - USA∗ Allow a normalization of monetary policy.∗ Could be done by ending its fiscal paralysis & implementing a fiscal stimulus package coupled with a credible medium-term fiscal rule to deal with dangerous medium-term debt dynamics.∗ Rework tax & other policies to incentivize savings rather than consumption.
GREECE CRISES - THE BEGINNING ∗ After US Recession, Eurozone Financial Crises begin. ∗ European Financial Institutions under Stress. ∗ BNP-Paribas forced to close funds in August 2007 ∗ UK bank Northern Rock taken over by government ∗ German state banks IKB, WestLB, BayernLB and SachsenLB bailed out by government ∗ Irish banks given government deposit guarantees ∗ Switzerland injects funds into UBS
Monetary Policy Response by European Central Bank (ECB)∗ ECB injected liquidity into European banks unable to obtain short-term funds in market.∗ Federal Reserve used Euro-dollar swaps to make dollars available to ECB to lend to banks.∗ ECB did not lower interest rates until October 2008 because of its focus on inflation.∗ Euro fell against the dollar due to “safe haven” flight to US Treasury securities.
Greece’s Financial Problems• Since joining the euro, Greece has had higher inflation than other Eurozone members.• Greece has also increased debt faster than others to finance generous public sector pay, welfare, and retirement benefits, while collecting a lower share in taxes due to widespread tax evasion.• As a result, Greek goods have become increasingly expensive and uncompetitive, causing loss of market share and further reducing revenues.
GREECE SITUATION∗ A country of 11.2 million and GDP of US$ 360 billion, representing 2.8% of Eurozone and 27th biggest economy in the world∗ Highest debt-GDP ratios in the world: 113% of GDP∗ Highest budget deficits in the world: 12.9% of GDP∗ Current account deficit: 11.0% of GDP∗ High degree of net foreign debt: 70% of GDP∗ Greece’s total outstanding public debt amounts to 290 billion euro
The Greek Debt Crisis• Foreign bondholders became doubtful that Greece could continue to roll over its increasing debt, forced interest rates higher.• EU faced choice between Greek default and bailout with tough conditions.• IMF and EU agreed to lend Greece up to $146 billion over three years.• Greece to increase sales taxes, reduce public sector salaries, pensions, eliminate bonuses.
USD-EURO EXCHANGE RATE∗ Between 2001 and 2011 Euro has appreciated by 65% against the US Dollar, undermining the competitiveness of Greek exports.