“Foreign Exchange Risk Management” at Rolex Rings Pvt. Ltd., Rajkot

Shri Sunshine Group of Education
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Declaration
I hereby declare that I had a good learning experience in doing this project titled
“Foreign Exchange Risk Management” at Rolex Rings Pvt. Ltd., Rajkot submitted in
partial fulfillment of the requirements for the degree of MBA program of Gujarat
University.
I hereby declare that the project done by me is true to knowledge. The project
duration was of weeks. The content of this report is based on the information
collected from different sources and the company itself.
I further declare that this project report has not been submitted to any other
university or institute for the award of any degree or diploma.
Date: Vishal Sitapara
Place: Rajkot

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Acknowledgement:
I take this opportunity to express my heartfelt gratitude to all the people who
have extended their assistance and provided me the information during the
tenure of the project. I am greatly indebted to them for their guidance and
support throughout the project and for sparing their valuable time with me.
I earnestly express to Mr. Manish Madeka for giving me this opportunity to work
with Rolex Rings Pvt. Ltd. and also to Mr. HirenDoshi and other staff members of
the firm for their invaluable guidance, cooperation and support during my
internship tenure.
I would also like to thank the Director of my college, Dr. SarlaAchuthan and
project guide Dr. PrateekKanchan for giving the opportunity to carry out the
project in the real world.
Thanking You,
Vishal Sitapara

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Table of Contents:
1) Executive Summary
2) Objectives and Scope
a) Objectives
b) Scope
3) Company Profile
a) Introduction
b) History
c) Management Team
d) Product Profile
e) Quality Policy
f) Environment
g) Bank Affiliation
4) Research Methodology
a) Type of Study
b) Secondary Data
c) Limitations
5) Introduction to FOREX Market
a) Introduction
b) Foreign Exchange Meaning
c) Requisites for FOREX Deals
d) Need for FOREX

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e) What does Foreign Exchange provide?
6) Foreign Exchange Market in India
a) Introduction
b) History
c) Modified LERMS
d) Exchange Rate Systems
e) Exchange Rate Systems in India
f) Factors affecting Exchange Rate
g) Factors affecting Indian Rupee
7) Foreign Exchange Exposure and Risk
a) Foreign Exchange Exposure
b) Foreign Exchange Risk
c) Differentiation of Exposure with Risk
8) FOREX Risk Management & Hedging Tools
a) FOREX Risk Management
b) Foreign Exchange Risk Management Framework
c) Determinants of Hedging Decisions
d) Hedging Tools
e) Risk Management Tools Available in India
f) Other Hedging Instruments
9) FOREX Risk Management at ROLEX RINGS
10) Findings & Conclusion
11) Bibliography

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Executive Summary
This project is based on the study of Foreign Exchange Risk Management at Rolex
Rings Pvt. Ltd.
Foreign Exchange, in common parlance, is the exchange of one currency for
another. This exchange is done at a particular rate called the exchange rate or the
FX rate. The FX rate is the price of one currency in terms of another. As is true
with rates, FX rate too is for a pre-determined settlement date i.e. the date on
which the actual exchange of the currencies involved would take place.
The Liberalized Exchange Rate Management System (LERMS) was introduced in
March 1992, and as a result, the foreign exchange market in India effectively
became a two-tier one, with a dual exchange rate system in force. One rate was
the administered one at which specified type or proportion was determined by
demand and supply in the market and applied to the remaining transactions. In
March 1993, this system was abolished and now a single market determined rate
is applicable for all transactions.
The volatility of exchange rates can’t be traced to a single reason and
consequently, it becomes very difficult to precisely define the factors that affect
exchange rates. The foreign exchange risk is related to the variability of the
domestic currency, values of assets, liabilities or operating income due to
unanticipated changes in exchange rates, whereas foreign exchange exposure is
what is at risk. FOREX risk is the variability in the profit due to change in foreign
exchange rate.
Business firms/companies like Rolex Rings have internationalized their activities
considerably. This trend has manifested itself not only in increased involvement in
international trade and foreign operations, but also in the fact that even firms
without explicit international transactions have become subject to the direct and
indirect effects of foreign competition to a much larger extent than in the past.

Thus, the impact of exchange rate changes on business operations tends to be
pervasive; the concern is not limited to specific financial functions such as
corporate treasury.
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Objectives and Scope
Objectives of the Study:
Main objectives of the study are as under:
1. To ascertain the FERM practices and product usage of Rolex Rings.
2. To know the attitudes, perceptions and concerns of the firm towards FERM.
3. To understand the level of awareness of derivatives and their uses, with Rolex
Rings.
4. To ascertain the organization structure, policymaking and control process
adopted by the firm, which use derivatives, in managing foreign exchange
exposure.
Scope:
The scope of this study is limited to the Foreign Exchange Risk Management and
the way Rolex Rings manages it. It has nothing to do with any kind of forecasts
about the currency movements.

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Company Profile

Introduction:
Established in 1980, Rolex Rings is the single largest manufacturer of hot forged
rolled rings in India and an emerging strong contender in the automotive
components space, catering to an array of multi-national companies across
countries such as Italy, France, Poland, Germany, Spain, USA, Mexico, China and
India. Rooted in the fertile grounds of hard beginnings and humble origins, Rolex
Rings, have survived and surpassed competitors and have become the leading
manufacturer of hot forged rolled rings along-with finished machining through
CNC route.
Today the company stands for engineering capability, customized solutions and
consolidated growth orientation. Its values of commitment to hard work and their
innate sense of responsibility towards providing the society with superior
products is the moving force behind their success saga.
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History:
The history of Rolex Rings since the day of its inception has been described as
under:
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Management Team:

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Product Profile:

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Quality Policy:
Pushing ahead with grueling schedules, punishing deadlines and a raging desire to
be beyond competition roles sets the bar high for quality standards at the
company.
Each stage of manufacturing at Rolex Rings reflects a profound presence of
excellence in quality. To meet the most exacting requirements of the most
demanding client, we have an array of sophisticated technology to ensure the
best of quality. High precision measuring instruments such as spectrometer,
electronic microscope, CMM, Contour measuring, Machine Profile Projector,
surface roughness tester etc. lay down the foundation for the quality of our
products.
Quality assurance activities for the manufacture of all the products of our plants
are closely coordinated at the following stages.
1. Raw Material
2. Statistical process control at the will press/machining
3. Acceptance test of forgings
4. Process and product quality audits
5. Packing
6. Transportation
Our employees contribute to the zero defect strategy.
Environment:
For any company in order to carry out its operations in the society, it becomes
very important on part of the company to take certain steps that protects the
environment and the society as a whole.
At Rolex Rings, we follow the following principles:

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 Healthy working environment for the employees.
 Continuous control of the raw material and energy consumption to save
resources.
 Continuously trying to reducing the waste.
 Installation of precautionary steps against accidents that may have negative
effects for the environment.
Our environmental policy targets to a continuous improvement of the companies
environmental pollution control.
Rolex Rings has green power technology of 8.75 MW, which helps us to save the
environment and also be more competitive.
At Rolex, we believe that our responsibilities to the environment do not end with
developing Green power technology. As our global footprint grows and we
become more a part of the world around us, we are taking every step necessary
to ensure that our activities, processes & services ensure minimal adverse
impact on the environment. We are committed to pollution control and use every
opportunity to conserve energy.
Bank Affiliation:
Rolex Rings Pvt. Ltd. has its accounts in the following banks:
1) Corporation Bank
2) Oriental Bank of Commerce
3) Union Bank of India
4) Bank of Baroda
5) Indian Overseas Bank

Research Methodology
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Introduction
This study aims to delineate the methodology, employed to undertake this study.
Research is a common parlance, which refers to a search for knowledge. One can
define research as scientific and systematic search for pertinent.
Research is of a great importance to find out the nature, extent and cause of the
research issue under study. Research methodology is the process in which various
steps generally adopted by a researcher are outlined.
Type of the study:
This is a descriptive study; analysis is made on the basis of the secondary data.
Secondary Data:
1) Publications
2) Articles
3) Websites
In this report, I have used the secondary data, most of which was obtained
from the internal records of the company. Data has also been gathered
from websites of RBI, X-Rates, NSE, FEDAI and Rolex Rings.
Limitations:
1) Lack of practical exposure in the area of Risk Management
2) Lack of formal sources of data

Introduction to Foreign
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Exchange Market

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Introduction:
The international currency market – the foreign exchange, is a special kind of the
world financial market. The Foreign exchange, also referred to as the “FOREX” or
“Spot FX” market, is the largest financial market in the world, with over $3.5
trillion changing hands every single day.
What is traded on the Foreign Exchange? The answer is money. FOREX trading is
where the currency of one nation is traded for that of another. A trader’s purpose
on this market is to get profit as the result of foreign currencies purchase and
sale in accordance with a known principle ‘Buy cheaper – Sell higher” and to
convert profits made in foreign currencies, buy or sell products or services in a
foreign country, into their domestic currency.FOREX trading is always traded in
pairs. The most commonly traded currency pairs are traded againstthe US Dollar
(USD). They are called ‘the majors’. The major currency pairs are the Euro Dollar
(EUR/USD), the British Pound (GBP/USD), the Japanese Yen (USD/JPY) and the
Swiss Franc (USD/CHF). As there is no central exchange for the FOREX market,
these pairs and their crosses are traded over the telephone and online through a
global network of banks, multinational corporations, importers and exporters,
brokers and currency traders, i.e. the FX market is considered as an Over The
Counter or ‘inter-bank’ market.
FOREX is different compared to all other sectors of the world financial system,
thanks to its heightened sensibility to a large and continuously changing number
of factors, accessibility to all individual and corporate traders, exclusively high
trade turnover which creates an ensured liquidity of traded currencies and the
round the clock business hours which enable traders to deal after normal hours or
during national holidays in their country finding markets abroad open. Also, just
as on any other market, the trading on FOREX along with an exclusively high
potential profitability, is essentially a risk bearing one.
Foreign Exchange – Meaning:

Foreign Exchange is the purchase or sale of a currency against the sale or
purchase of another, i.e. the exchange of one currency for another. This exchange
is done at a particular rate called the exchange rate or the FX rate. The FX rate is
the price of one currency in terms of another. As is true for rates, FX rate too is a
pre-determined settlement date, i.e. the date on which the actual exchange of
currencies involved would take place.
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Requisites for Foreign Exchange Deals:
 Exchange of two currencies
 At an agreed exchange rate
 For a specified settlement date
 Settlement instructions for receipt and payment
 Confidence that the terms of the trade will be adhered to
Need for Foreign Exchange:
In this global village, which has almost as many currencies as countries, business
activity would come to near standstill if each country insisted on dealing on its
own currency and none other. With the growing importance of international
trade and maturity in financial markets, the major international trade participants
have come to accept certain currencies as the “traded currencies” or “major
currencies”. These currencies are termed as such based on the strength of their
economies and their financial markets, the political backing of the countries,
international acceptability, liquidity and depth of their markets, economic and
political stability. The World Bank, leading international agencies and world
bodies have given a further boost to these currencies, using in their dealings too.
A country’s external reserves are denominated in these currencies. This is what
necessitates the Foreign Exchange.

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What does Foreign Exchange provide?
 The method or mechanism to conduct and settle the proceeds of
International Trade
 The means to obtain/provide technology, expertise and the sharing of
information
 The means to minimize the risks of currency fluctuations - primarily
through the use of various tools and financial instruments
 Trading opportunities to generate incremental income

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Foreign Exchange
Market in India

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Introduction:
The Foreign Exchange business in India is regulated closely by the RBI. With
Exchange Control Regulations, the RBI ensures that involvement in the Foreign
Exchange business is restricted to certain sections of the business community
only.
Main Participants:
 Corporate: Importers, Exporters and Customers for genuine trades or
merchant transactions
 Banks: Banks in India are permitted to buy and sell currencies abroad in
cover of customer requirements. They have also been permitted to initiate
positions abroad too. Overseas banks call banks in India to cover their
Indian rupee requirements.
 Overseas Traders: One authorized dealer dealing with another to generate
profit or cover its open exposure
 Authorized Dealers v/s RBI: This occurs only when the RBI intervenes in the
market and not in the normal course
RBI restrictions in terms of participation in foreign currencies are as under:
Corporate:
 Individuals as per the Exchange Control Manual (Retail)
 Importers, Exporters and Borrowers of Foreign Currencies (Wholesale)
Banks/Others:
 Money Changers (RMC’s and FFMC’s) licensed by the RBI to buy/sell
Foreign Currency Notes and Travelers Cheques from individuals (Retail)
 Banks licensed by the RBI to carry out foreign exchange business on a
commercial wholesale level, called the Authorized Dealers

Brokers: Brokers are permitted to bring together buyers and sellers but cannot
trade for their own account. This means they have to strike thedeal with the
buyers and sellers simultaneously.
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History of FOREX Market in India:
Until the early seventies, given the fixed rate regime, the foreign exchange market
was perceived as a mechanism merely to put through merchant transactions.
With the collapse of the Bretton Woods agreement and the floatation of major
currencies, the conduct of exchange rate policy posed a great challenge to central
banks as currency fluctuations opened up tremendous opportunities for market
players to trade in currency volatilities in a borderless market.
The market in India, however, remained insulated as exchange rate controls
inhibited capital movements and the banks were required to undertake cover
operations and maintain a square position at all times.
Slowly a demand began to build up that banks in India be permitted to trade in
FOREX. In response to this demand the RBI, as a first step, permitted banks to
undertake intraday trade in FOREX in 1978. As a consequence, the stipulation of
maintaining square or near square position was to be complied with only at the
close of business each day.
As the opportunities to make profit began to emerge, the major banks started
quoting two-way prices against the Rupee as well as in cross currencies (Non-
Rupee) and gradually, trading volumes began to increase. This was enabled by a
major change in the exchange rate regime in 1975 whereby the Rupee was
delinked from the Pound Sterling ad under a managed floating arrangement, the
external value of the Rupee was determined by the RBI in terms of weighted
basket of currencies of India’s major trading partners. Given the RBI’s obligation
to buy and sell unlimited amounts of Pound Sterling (the intervention currency),
arising from the bank’s merchant trades, and its quotes for buying/selling
effectively became the fulcrum around which the market moved.

As the volumes increased, the appetite for profits was found to lead the
observance of widely different practices dictated largely by the size of the players,
their location, expertise of the dealing staff and availability of communications
facilities, it was thought necessary to draw up a comprehensive set of guidelines
covering the entire gamut of dealing operations to be observed by banks engaged
in FOREX business. Accordingly, in 1981 the “Guidelines for Internal Control over
Foreign Exchange Business” was framed for adoption by banks.
During the eighties, deterioration in the macro-economic situation set in,
ultimately warranting a structural change in the exchange rate regime, which in
turn had an impact on the FOREX market. Large and persistent external
imbalances were reflected in rising level of internal indebtedness. The graduated
depreciation of the Rupee could not compensate for the widening inflation
differentials between India and the rest of the world and the exchange rate of the
Rupee was getting increasingly overvalued. The Gulf problems of August 1990,
given the fragile state of the economy, triggered off an unprecedented crisis of
liquidity and confidence. This unprecedented crisis called for the adoption of
exceptional corrective steps. The country simultaneously embarked upon the
measures of adjustment to stabilize the economy and got in motion structural
reforms to generate renewed impetus for stable growth.
As a first step in this direction, the RBI effected a two-step downward adjustment
of the Rupee in July 1991. Simultaneously, in order to provide a closer alignment
between exports and imports, the EXIM scrip scheme was introduced. The
scheme provided a boost to exports and with the experience gained in the
working of the scheme, it was thought prudent to institutionalize the incentive
component and convey it through the price mechanism, while simultaneously
insulating essential imports from currency fluctuations. Therefore, with effect
from March 1, 1992, RBI instituted a system of dual exchange rates under the
Liberalized Exchange Rate Management System (LERMS). Under this, 40% of the
exchange earnings had to be surrendered at a rate determined by the RBI and the
RBI was obliged to sell foreign exchange only for imports of essential commodities
such as oil, fertilizers, life-saving drugs etc., besides the government’s debt
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servicing. The balance could be converted at rates determined by the market. The
scheme worked satisfactorily preparing the market for its emerging role and the
Rupee remained fairly stable with the spread between the official and the market
rate hovering around 17%.
Even though the dual exchange rate system worked well, it however, implied an
implicit tax on exporters and remittances. Moreover, it distorted the efficient
allocation of resources. The LERMS was essentially a transitional mechanism and
in March 1993, the two legs of the exchange rates were unified and christened
Modified LERMS. It stipulated that from March 2, 1993, all FOREX receipts could
be converted at market determined rates of exchange. Over the next eighteen
months, restrictions on a number of other current account transactions were
relaxed and on August 20, 1994, the Rupee was made fully convertible for all
current account transactions and the country formally accepted the obligations
under Article VIII of the IMF’s article of agreement.
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Changes that took place:
 1966 – The rupee was devalued by 57.5% on June 6
 1967 – Rupee-Sterling parity change as a result of devaluation of the
Sterling
 1971 – Bretton Woods system broke down in August. Rupee briefly pegged
to the USD @ Rs. 7.5 before reneging to Sterling at Rs. 18.87 with a 2.25%
margin on either side
 1972 – Sterling floated on June 23. Rupee-Sterling parity revalued to Rs.
18.95 and then in October to Rs. 18.80
 1975 – Rupee pegged to an undisclosed basket with a margin of 2.25% on
either side. Sterling, the intervention currency with a central bank rate of
Rs. 18.31
 1979 – Margins around basket parity widened to 5% on each side in January
 1991 – Rupee devalued by 19.5% in July 1st and Rupee-Dollar rates
depreciated from Rs. 21.20 to Rs. 25.80. A version of dual exchange rate

introduced through EXIM scrip scheme, given exporters freely tradable
import entitlements equivalent to 30-40% of export earnings.
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 1992 – LERMS introduced with a 40-60 dual rate converting export
proceeds, market determined rates or all but specified imports and market
rate for approved capital transaction. US Dollar became the intervention
currency from March 4th. EXIM scrip abolished.
 1993 – Unified market determined exchange rate introduced for all
transactions. RBI would buy/sell US Dollars for specified purposes. It will
not buy/sell Dollar Forwards though it will enter into Dollar Swaps.
 1994 – Rupee made fully convertible on current account from August 20th
 1998 – Foreign Exchange Management Act – FEM Bill 1998 which was
placed in the Parliament to replace FERA
 1999 – Implication of FEMA starts
Modified Liberalized Exchange Rate Management System:
The process of liberalization continued further and it was decided to make the
Rupee fully floating with effect from March 1, 1993. This new arrangement is
called Modified LERMS. Its salient features are as under:
Effective from March 1, 1993, all foreign exchange transactions, receipts and
payments, both under current and capital accounts of Balance of Payments are
being put through by authorized dealers at market determined exchange rates.
Foreign exchange receipts and payments, however, continued to be governed by
the Exchange Control Regulations. Foreign exchange receipts are to be
surrendered to the authorized dealers except in cases where the residents have
been permitted by the RBI to retain them either with the banks in India or abroad.
Authorized dealers are free to retain the entire foreign exchange surrendered to
them for being sold for permissible transactions and are not required to surrender
to the Reserve Bank any portion of such receipts.

Reserve Bank of India, under section 40 of RBI Act 1934, was obliged to buy and
sell foreign exchange to authorized dealers. Reserve Bank is now required to sell
any authorized person at its offices/branches US Dollars for meeting foreign
exchange payments at its exchange rates based on the market rate only for such
purposes as are approved by the Central Government. The RBI buys spot US
Dollars from authorized dealers at its exchange rate. Reserve Bank does not
ordinarily buy spot Pound Sterling, Deutsche Mark and Japanese Yen. It does not
buy any forward currency. The exchange rate at which the RBI buys and sells
foreign exchange is in the +5/-5% band of the market rate. Also, the RBI
announces the reference rate at 12:00 hours which is the rate at which
transactions with IMF, IBRD etc. are undertaken.
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Advantages of the New System:
 The system seeks to ensure equilibrium between demand and supply with
respect to a fairly large subset of external transactions.
 It has facilitated removal of several trade restrictions and granted
relaxation in exchange control (under current account transactions).
 It is a step towards full convertibility of current account transactions in
order to achieve the full benefits of integrating the Indian economy with
the world economic system.
 The incentives to exporters will be higher and more particularly to those
whose exports are not highly import intensive. Exporters of agricultural
products will find exports attractive.
 A large number of expatriates, who are hitherto denied any advantages on
their remittances to India in line with the earnings of the exporters, are
now eligible for market rate for the full amount of remittances being in
nature of capital inflows.
 This system, coupled with the Exchange Control Relaxation in certain areas,
and the abolition of travel tax is expected to make the havala route less
tempting. In this context, it needs to be remembered that smaller the gap
between the average rate received by the exporters and other earners of

foreign exchange and the market rate, the lesser will be the temptation to
continue using illegal channels for remittances.
 In the fiscal area, customs revenue is likely to be higher, other things being
the same, to the extent the valuation of imports would be based on the
market exchange rate. It is, however, necessary to ensure that the tariff
rates together with higher input values do not result in a sharp increase in
import costs.
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Exchange Rate System:
Countries of the world have been exchanging goods and services amongst
themselves. This has been going on since time immemorial. The world has come a
long way from the days of Barter trade. With the invention of money, the figures
and problems of barter trade have disappeared.
Different countries have adopted different exchange rate systems at different
times. Following are the exchange rate systems followed by various countries:
 The Gold Standard, 1816-1933:
The 'gold standard' used the physical weight of gold as the standard value
for the money and making it directly exchangeable in the form of the
precious metal. In 1816 for instance, the pound sterling was defined as
123.27 grains of gold on its way to becoming the foremost reserve currency
and was the principal component of the international capital market. This
led to the expression 'as good as gold' when applied to the Sterling, as the
Bank of England at the time gained stability and prestige as the premier
monetary authority. Before the First World War, most Central banks
supported their currencies with convertibility to gold. Paper money could
always be exchanged for gold. For this type of gold exchange, a central
bank coverage backing up the government’s currency reserves was not

necessarily needed. When a group mindset fostered a disastrous notion of
converting back to gold in mass, panic resulted in so-called "Run on banks”.
The US dollar adopted the gold standard late in 1879 and became the
standard-bearer replacing the British Pound when Britain and the other
European countries came off the system with the outbreak of World War I
in 1914. Eventually, though, the worsening international depression lead
even the dollar off the gold standard by 1933 marking the period of
collapse in international trade and financial flows prior to World War II.
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 Purchasing Power Parity:
Professor Gustav Cassel, a Swedish Economist, introduced this system. The
theory to put in simple terms states that the currencies are valued for what
they can buy. Thus if 135 JPY buy a fountain pen and the same fountain pen
can be bought for USD 1, it can be inferred that since 1 USD or 135 JPY can
buy the same fountain pen, therefore, 1 USD = 135 JPY.
For example, if country A had a higher rate of inflation as compared to
country B, then the goods produced in country A would become costlier as
compared to goods produced in country B. This would induce imports into
country A and also the goods produced in country A being costlier, would
lose in international competition to goods produced in country B. This
decrease in exports of country A as compared to exports from country B
would lead to demand for the currency of country B and excess supply of
currency of country A. This in turn, causes currency of country A to
depreciate in comparison of country B which is having relatively higher
exports.
 The Bretton Woods System, 1944-73:
The Gold Standard partly, fixing the USD at $35.00 per ounce of Gold and
fixing the other main currencies to the dollar, initially intended to be on a
permanent basis. The Bretton Woods system formalized the role of the US
dollar as the new 'global' reserve currency with its value fixed into gold and
the US assuming the responsibility of ensuring convertibility while other
currencies were pegged to the dollar.

In Asia, the lack of sustainability of fixed foreign exchange rates has gained
new relevance with the events in the latter part of 1997, where currencies
were forced to float. Currency after currency was devalued against the US
dollar. The devaluation of currencies continued to plague the currency
trading markets, and confidence in the open market of FOREX trading was
not sustained. Leaving other fixed exchange rates in particular in South
America also looking very vulnerable. While commercial companies have
had to face a much more volatile currency environment in recent years,
investors and financial institutions have discovered a new playground. The
size of the FOREX market now dwarfs any other investment market.
The last few decades have seen foreign exchange trading develop into the
world’s largest global market. Restrictions on capital flows have been
removed in most countries, leaving the market forces free to adjust foreign
exchange rates according to their perceived values. In the 1980s, cross-border
capital movements accelerated with the advent of computers and
technology, extending market continuum through Asian, European and
American time zones. Transactions in foreign exchange rocketed from
about $70 billion a day in the 1980s, to more than $1.5 trillion a day two
decades later.
The collapse of PPP System brought the Bretton Woods System, and after
its collapse, the Smithsonian Agreement. At present, the Floating Rate
System is used in almost all the countries.
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Exchange Rate System in India:
The Rupee was historically linked i.e. pegged to the Pound Sterling. Earlier, during
the British regime and till late sixties, most of India’s trade transactions were
dominated by Pound Sterling. Under Bretton Woods System, as a member of IMF,
India declared its par value of Rupee in terms of gold. The corresponding Rupee -
Sterling rate was fixed at 1 GBP = Rs. 18.
When Bretton Woods System bore down in August 1971, the Rupee was delinked
from US Dollar and the exchange rate was fixed at 1 USD = Rs. 7.5. Reserve Bank
of India, however, kept the Pound Sterling as the currency of intervention. The
USD and Rupee pegging was used to arrive at Rupee-Sterling parity. After
Smithsonian Agreement in December 1971, the Rupee was delinked from USD
and again linked to Pound Sterling. This parity was maintained with a band of
2.25%. Due to poor fundamentals, Pound got depreciated by 20% which in turn
caused the Rupee to depreciate.
To be not dependent on a single currency, Pound Sterling, on September 25,
1975, Rupee was delinked from it and was linked to the basket of currencies with
their relative weights kept as a secret so that the speculators didn’t get the wind
of the direction of the movement of exchange rate of Rupee.
From January 1, 1984 the Sterling rate schedule was abolished. The interest
element which was hitherto in building the exchange rate was also delinked. The
interest rate was to be recovered from the customers separately. This not only
allowed transparency in the exchange rate quotations but also was in tune with
international practice in this regard. FEDAI issued guidelines for calculation of
merchant rates.
The liquidity crunch in 1990 and 1991 on FOREX front only hastened the process.
On March 1, 1992, Reserve Bank of India announced a new system of exchange
rates known as the Liberalized Exchange Rate Management System.
LERMS was to make balance of payments sustainable on ongoing basis allowing
the market force to play a greater role in determining the exchange rate of Rupee.
Under LERMS, the Rupee became convertible for all approved external
transactions. The exporters of goods and services and those who received
remittances from abroad were allowed to sell bulk of their FOREX receipts.
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Similarly, those who needed foreign exchange to import and travel abroad were
to buy foreign exchange from market determined rate.
From March 1, 1993 Modified LERMS under which all the FOREX transactions,
under current and capital account, are being put through by Authorized Dealers at
market determined exchange rate.
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Factors Affecting Exchange Rates:
Various economic variables impact the movement in exchange rates. Interest
rates, inflation figures, GDP are the main variables; however other economic
indicators that provide direction regarding the state of the economy also have
a significant impact on the movement of a currency. These would include
employment reports, balance of payment figures, manufacturing indices,
consumer prices and retail sales amongst others. Indicators which suggest that
the economy is strengthening are positively correlated with a strong currency
and would result in the currency strengthening and vice versa.
Currency trader should be aware of government policies and the central bank
stance as indicated by them from time to time, either by policy action or
market intervention. Government structures its policies in a manner such that
its long term objectives on employment and growth are met. In trying to
achieve these objectives, it sometimes has to work around the economic
variables and hence policy directives and the economic variables are entwined
and have an impact on exchange rate movements.
Factors Affecting Indian Rupee:
As we know that FOREX market for Indian currency is highly volatile where one
cannot forecast the exchange rates easily as there is a mechanism which works
behind the determination of exchange rate. One of the most important factors
which affect the exchange rate is the demand and supply of the domestic and

foreign currency. There are some other factors also which are having major
impact on the exchange rate determination. These are:
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 Market Situation:
India follows the “Floating Rate System” for determining the exchange rate.
In this system, market situation also is pivot for determining exchange rate.
As we know that 90% of the FOREX market is between the banks and so
how the banks are taking the decision for settling out their different
exposures in the domestic or foreign currency is impacting the exchange
rate. Apart from the banks, transactions of exporters and importers are
having impact on this market. So in the day-to-day FOREX market, on the
basis of the bank and trader’s transactions, the demand and supply of the
currencies increase or decrease and that is deciding the exchange rate.
 Economic Factors:
In the FOREX market, economic factors of the country play an important
role. The growth and development of any country depends on how stable
its economy is. Herein, there are two types of economic factors which
affect the exchange rate:
1. Internal Factors:
(a) Fiscal Deficit of the country
(b) GDP and GNP of the country
(c) Inflation Rate
(d) Agricultural Growth and Production
(e) Infrastructure
(f) Policies like EXIM policy, Credit Policy as well as the reforms
undertaken in the yearly budget
(g) Foreign Exchange Reserves
2. External Factors:
(a) Export – Import trade with foreign countries
(b) Relationship with foreign countries
(c) International Oil and Gold prices
(d) Foreign Direct Investment, Portfolio investment
(e) Loan sanction by World Bank and IMF

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 Political Factors:
Political factors also play an important role in determining the exchange
rate. The party forming the Government after winning the elections held
every five years also play a pivot role. Political stability helps improving the
exchange rates whereas on the other hand, political uncertainty leads to
the depreciation of the currency. The instability in the year 1999 led to the
depreciation of Rupee by 30 paise in April.

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Foreign Exchange
Exposure and Risk:

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Foreign Exchange Exposure:
Description:
Foreign exchange risk is related to the variability of the domestic currency values
of assets, liabilities or operating income due to unanticipated changes in
exchange rates, whereas foreign exchange exposure is what is at risk.
Foreign currency exposures and the attendant risk arise whenever a company has
an income or expenditure or an asset or liability in a currency other than that of
the balance-sheet currency. Indeed exposures can arise even for companies with
no income, expenditure, asset or liability in a currency different from the balance-sheet
currency.
When there is a condition prevalent where the exchange rates become extremely
volatile, the exchange rate movements destabilize the cash flows of a business
significantly. Such destabilization of cash flows that affects the profitability of the
business is the risk from foreign currency exposures.
Classification of Exposures:
Financial economists distinguish between three types of currency exposures –
Transaction Exposures, Translation Exposures and Economic Exposures. All three
affect the bottom-line of the business.
 Transaction Exposure:
The transaction exposure component of the foreign exchange rates is also
referred to as a short-term economic exposure. This relates to the risk
attached to specific contracts in which the company has already entered
that result in foreign exchange exposures. A company may have a
transaction exposure if it is either on the buy side or sell side of a business
transaction. Any transaction that leads to an inflow or outflow of a foreign
currency results in a transaction exposure.
For example, Company A located in the United States has a contract for
purchasing raw material from Company B located in the United Kingdom
for the next two years at a product price fixed today. In this case, Company

A is the foreign exchange payer and is exposed to a transaction risk from
movements in the pound rate relative to dollar. If the pound sterling
depreciates, Company A has to make a smaller payment in dollar terms, but
if the pound appreciates, Company A has to pay a larger amount in dollar
terms leading to foreign currency exposure.
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Transaction exposure arises from:
 Purchasing or selling on credit goods or services whose prices are stated in
foreign currencies.
 Borrowing or lending funds when repayment is to be made in a foreign
currency.
 Being a party to an unperformed foreign exchange forward contract.
 Otherwise acquiring assets or incurring liabilities denominated in foreign
currencies.
Strategy to manage Transaction Exposure:
 Hedging through invoice currency:
The firm can shift, share or diversify exchange risk by appropriately
choosing the currency of invoice. Firms can avoid exchange rate risk by
invoicing in domestic currency, thereby shifting the exchange rate risk on
buyer.
As a practical matter, however, the firm may not be able to use risk shifting
or sharing as much as it wishes to for fear of losing sales to competitors.
Only an exporter with substantial market power can use this approach.
Also, if the currencies of both the importer and exporter are not suitable
for settling international trade, neither party can resort to risk shifting to
deal with exchange exposure.
 Hedging via lead and lag:
To “lead” means to pay or collect early, whereas “lag” means to pay or
collect late. The firm would like to lead soft currency receivables and lag
hard currency receivables to avoid the loss from depreciation of the soft
currency and benefit from the appreciation of the hard currency. For the

same reason, the firm will attempt to lead the hard currency payables and
lag soft currency payables. To the extent that the firm can effectively
implement the lead/lag strategy, the transaction exposure the firm faces
can be reduced.
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 Translation Exposure:
Translation exposure of foreign exchange is of an accounting nature and is
related to a gain or loss arising from the conversion or translation of the
financial statements of a subsidiary located in another country.
A company such as General Motors may sell cars in about 200 countries
and manufacture those cars in as many as 50 different countries. Such a
company owns subsidiaries or operations in foreign countries and is
exposed to translation risk. At the end of the financial year the company is
required to report all its combined operations in the domestic currency
terms leading to a loss or gain resulting from the movement in various
foreign currencies.
 Economic Exposure:
Economic exposure is a rather long-term effect of the transaction exposure.
If a firm is continuously affected by an unavoidable exposure to foreign
exchange over the long-term, it is said to have an economic exposure. Such
exposure to foreign exchange results in an impact on the market value of
the company as the risk is inherent to the company and impacts its
profitability over the years.
A beer manufacturer in Argentina that has its market concentration in the
United States is continuously exposed to the movements in the dollar rate
and is said to have an economic foreign exchange exposure.
Economic exposure consists of mainly two types of exposures. They are:
1) Asset Exposure
2) Operating Exposure
Economic risk is difficult to quantify but a favored strategy to manage it is
to diversify internationally, in terms of sales, location of production

facilities, raw materials and financing. Such diversification is likely to
significantly reduce the impact of economic exposure relative to a purely
domestic company, and provide much greater flexibility to react to real
exchange rate changes.
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Foreign Exchange Risk:
Nature of Foreign Exchange Risk:
Foreign Exchange dealing is a business that one get involved in, primarily to
obtain protection against adverse rate movements on their core international
business. Foreign Exchange dealing is essentially a risk-reward business where
profit potential is substantial but it is extremely risky too.
Foreign exchange business has the certain peculiarities that make it a very risky
business. These would include:
 FOREX deals are across country borders and therefore, often foreign
currency prices are subject to controls and restrictions imposed by foreign
authorities. Needless to say, these controls and restrictions are invariably
dictated by their own domestic factors and economy.
 FOREX deals involve two currencies and therefore, rates are influenced by
domestic as well as international factors.
 The FOREX market is a 24-hour global market and overseas developments
can affect rates significantly.
 The FOREX market has great depth and numerous players shifting vast
sums of money. FOREX rates therefore, can move considerably, especially
when speculation against a currency rises.
 FOREX markets are characterized by advanced technology, communications
and speed. Decision-making has to be instantaneous.
Description of Foreign Exchange Risk
In simple word FOREX risk is the variability in the profit due to change in foreign
exchange rate. Suppose the company is exporting goods to foreign company then

it gets the payment after month or so then change in exchange rate may effect in
the inflows of the fund. If rupee value depreciated he may lose some money.
Similarly if rupees value appreciated against foreign currency then it may gain
more rupees. Hence there is risk involved in it.
Classification of Foreign Exchange Risk
 Position Risk
 Gap or Maturity or Mismatch Risk
 Translation Risk
 Operational Risk
 Credit Risk
1. Position Risk
The exchange risk on the net open FOREXposition is called the position risk. The
position can be a long/overbought position or it could be a short/oversold
position. The excess of foreign currency assets over liabilities is called a net long
position whereas the excess of foreign currency liabilities over assets is called a
net short position. Since all purchases and sales are at a rate, the net position too
is at a net/average rate. Any adverse movement in market rates would result in a
loss on the net currency position.
For example, where a net long position is in a currency whose value is
depreciating, the conversion of the currency will result in a lower amount of the
corresponding currency resulting in a loss, whereas a net long position in an
appreciating currency would result in a profit. Given the volatility
in FOREX markets and external factors that affect FX rates, it is prudent to have
controls and limits that can minimize losses and ensure a reasonable profit.
The most popular controls/limits on open position risks are:
 Daylight Limit: Refers to the maximum net open position that can be built up a
trader during the course of the working day. This limit is set currency-wise and
the overall position of all currencies as well.
 Overnight Limit: Refers to the net open position that a trader can leave
overnight – to be carried forward for the next working day. This limit too is set
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currency-wise and the overall overnight limit for all currencies. Generally,
overnight limits are about 15% of the daylight limits.
2. Mismatch Risk/Gap Risk
Where a foreign currency is bought and sold for different value dates, it creates
no net position i.e. there is no FX risk. But due to the different value dates
involved there is a “mismatch” i.e. the purchase/sale dates do not match. These
mismatches, or gaps as they are often called, result in an uneven cash flow. If the
forward rates move adversely, such mismatches would result in losses.
Mismatches expose one to risks of exchange losses that arise out of adverse
movement in the forward points and therefore, controls need to be initiated.
The limits on Gap risks are:
 Individual Gap Limit: This determines the maximum mismatch for any
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calendar month; currency-wise.
 Aggregate Gap Limit: Is the limit fixed for all gaps, for a currency, irrespective
of their being long or short. This is worked out by adding the absolute values of
all overbought and all oversold positions for the various months, i.e. the total
of the individual gaps, ignoring the signs. This limit, too, is fixed currency-wise.
 Total Aggregate Gap Limit: Is the limit fixed for all aggregate gap limits in all
currencies.
3. Translation Risk
Translation risk refers to the risk of adverse rate movement on foreign currency
assets and liabilities funded out of domestic currency.
There cannot be a limit on translation risk but it can be managed by:
1. Funding of Foreign Currency Assets/Liabilities through money markets i.e.
borrowing or lending of foreign currencies
2. Funding through FX swaps
3. Hedging the risk by means of Currency Options
4. Funding through Multi Currency Interest Rate Swaps
4. Operational Risk

The operational risks refer to risks associated with systems, procedures, frauds
and human errors. It is necessary to recognize these risks and put adequate
controls in place, in advance. It is important to remember that in most of these
cases corrective action needs to be taken post-event too. The following areas
need to be addressed and controls need to be initiated.
 Segregation of trading and accounting functions: The execution of deals is a
function quite distinct from the dealing function. The two have to be kept
separate to ensure a proper check on trading activities, to ensure all deals are
accounted for, that no positions are hidden and no delay occurs.
 Follow-up and Confirmation: Quite often deals are transacted over the phone
directly or through brokers. Every oral deal has to be followed up immediately by
written confirmations; both by the dealing departments and by back-office or
support staff. This would ensure that errors are detected and rectified
immediately.
 Settlement of funds: Timely settlement of funds is necessary not only to avoid
delayed payment interest penalty but also to avoid embarrassment and loss of
credibility.
 Overdue contracts: Care should be taken to monitor outstanding contracts and to
ensure proper settlements. This will avoid unnecessary swap costs, excessive
credit balances and overdrawn Nostro accounts.
 Float transactions: Often retail departments and other areas are authorized to
create exposures. Proper measures should be taken to make sure that such
departments and areas inform the authorized persons/departments of these
exposures, in time. A proper system of maximum amount trading authorities
should be installed. Any amount in excess of such maximum should be transacted
only after proper approvals and rate.
5. Credit Risk
Credit risk refers to risks dealing with counter parties. The credit is contingent
upon the performance of its part of the contract by the counter party. The risk is
not only due to non-performance but also at times, the inability to perform by the
counter party.
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The credit risk can be:
 Contract risk: Where the counter party fails prior to the value date. In such
a case, the FOREX deal would have to be replaced in the market, to
liquidate the FOREX exposure. If there has been an adverse rate movement,
this would result in an exchange loss. A contract limit is set counter party-wise
to manage this risk.
 Clean risk: Where the counter party fails on the value date i.e. it fails to
deliver the currency, while you have already paid up. Here the risk is of the
capital amount and the loss can be substantial. Fixing a daily settlement
limit as well as a total outstanding limit, counter party-wise can control
such a risk.
 Sovereign Risk: refers to risks associated with dealing into another country.
These risks would be an account of exchange control regulations, political
instability etc. Country limits are set to counter this risk.
Differentiation of Exposure with Risk
Even though foreign exchange risk and exposure have been the central issues of
International Financial Management for many years, a considerable degree of
confusion remains about their nature and measurement.
For instance, it is not uncommon to hear the term “Foreign Exchange Exposure”
used interchangeably with the term ‘Foreign Exchange Risk” when in fact they
conceptually completely different. Foreign Exchange Risk is related to the
variability of domestic currency of assets, liabilities or operating incomes due to
unanticipated changes in exchange rates whereas Foreign Exchange Exposure is
what is at risk.

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Foreign Exchange Risk
Management and Hedging
Tools

FOREX Risk Management:
Description:
As a business engaged in the buying and selling of goods/services overseas, a
company is exposed to foreign exchange risks. These risks arise from the
fluctuations in the currency market, which will impact outgoing payments for
imports or incoming funds from exports. Changes in the exchange rate between
two currencies will translate into additional profits or losses to the payables or
receivables. The amount of risk depends on factors such as the volatilities of the
currencies involved and the value of the contract.
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Objectives of Risk Management:
 To minimize costs
 To maximize revenue
 To stabilize margins in the future
Understanding the Risk:
 Identify your exposure:
Risk is not just limited to imports and exports. It can exist for any area of a
business that has an international component and requires foreign funds.
For example, these can include:
i) Goods and services for import/export
ii) Company assets that are purchased from a supplier abroad
iii) Operational costs for overseas offices or factories (such as rent,
equipment, payroll etc.)
iv) Staff’s global travel expenses
 Calculate your exposure:
Figure out the sum value of all the components of business that are
exposed to foreign exchange risk. Then calculate as to what would happen
if one currency falls or rises by a certain amount against another currency.
Also consider the timeframe for payables or receivables, and the
corresponding profits or losses over 30-60-90 days.
 Confirm your company’s foreign exchange objectives:

Each company will have a different approach to foreign exchange that is
based upon their industry, trade volumes, geographical markets etc. To
develop one’s own company’s strategy, it is important to understand
whether or not a company is risk-adverse, the level of risks for the
currencies you deal with and how sophisticated your knowledge is
regarding financial services.
Foreign Exchange Risk Management Framework
Once a firm recognizes its exposure, it then has to deploy resources in managing
it. A heuristic for firms to manage this risk effectively is presented below which
can be modified to suit firm-specific needs i.e. some or all the following tools
could be used.
1. Forecasts: After determining its exposure, the first step for a firm is to develop
a forecast on the market trends and what the main direction/trend is going to be
on the foreign exchange rates. The period for forecasts is typically 6 months. It is
important to base the forecasts on valid assumptions. Along with identifying
trends, a probability should be estimated for the forecast coming true as well as
how much the change would be.
2. Risk Estimation: Based on the forecast, a measure of the Value at Risk (the
actual profit or loss for a move in rates according to the forecast) and the
probability of this risk should be ascertained. The risk that a transaction would fail
due to market-specific problems should be taken into account. Finally, the
Systems Risk that can arise due to inadequacies such as reporting gaps and
implementation gaps in the firms’ exposure management system should be
estimated.
3. Benchmarking: Given the exposures and the risk estimates, the firm has to set
its limits for handling foreign exchange exposure. The firm also has to decide
whether to manage its exposures on a cost center or profit center basis. A cost
center approach is a defensive one and the main aim is ensure that cash flows of
a firm are not adversely affected beyond a point. A profit center approach on the
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other hand is a more aggressive approach where the firm decides to generate a
net profit on its exposure over time.
4. Hedging: Based on the limits a firm set for itself to manage exposure, the firms
then decides an appropriate hedging strategy. There are various financial
instruments available for the firm to choose from: futures, forwards, options and
swaps and issue of foreign debt.
Hedging strategies and instruments are explored in a section.
5. Stop Loss: The firms risk management decisions are based on forecasts which
are but estimates of reasonably unpredictable trends. It is imperative to have stop
loss arrangements in order to rescue the firm if the forecasts turn out wrong. For
this, there should be certain monitoring systems in place to detect critical levels in
the foreign exchange rates for appropriate measure to be taken.
6. Reporting and Review: Risk management policies are typically subjected to
review based on periodic reporting. The reports mainly include profit/ loss status
on open contracts after marking to market, the actual exchange/ interest rate
achieved on each exposure and profitability vis-à-vis the benchmark and the
expected changes in overall exposure due to forecasted exchange/ interest rate
movements. The review analyses whether the benchmarks set are valid and
effective in controlling the exposures, what the market trends are and finally
whether the overall strategy is working or needs change.
Determinants of Hedging Decisions:
The management of foreign exchange risk, as has been established so far, is a
fairly complicated process. A firm, exposed to foreign exchange risk, needs to
formulate a strategy to manage it, choosing from multiple alternatives. This
section explores what factors firms take into consideration when formulating
these strategies.
I. Production and Trade vs. Hedging Decisions
An important issue for multinational firms is the allocation of capital among
different countries production and sales and at the same time hedging their
exposure to the varying exchange rates. Research in this area suggests that the
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elements of exchange rate uncertainty and the attitude toward risk are irrelevant
to the multinational firm's sales and production decisions (Broll, 1993). Only the
revenue function and cost of production are to be assessed, and, the production
and trade decisions in multiple countries are independent of the hedging
decision. The implication of this independence is that the presence of markets for
hedging instruments greatly reduces the complexity involved in a firm’s decision
making as it can separate production and sales functions from the finance
function. The firm avoids the need to form expectations about future exchange
rates and formulation of risk preferences which entails high information costs.
II. Cost of Hedging
Hedging can be done through the derivatives market or through money markets
(foreign debt). In either case the cost of hedging should be the difference
between value received from a hedged position and the value received if the firm
did not hedge. In the presence of efficient markets, the cost of hedging in the
forward market is the difference between the future spot rate and current
forward rate plus any transactions cost associated with the forward contract.
Similarly, the expected costs of hedging in the money market are the transactions
cost plus the difference between the interest rate differential and the expected
value of the difference between the current and future spot rates. In efficient
markets, both types of hedging should produce similar results at the same costs,
because interest rates and forward and spot exchange rates are determined
simultaneously. The costs of hedging, assuming efficiency in foreign exchange
markets result in pure transaction costs. The three main elements of these
transaction costs are brokerage or service fees charged by dealers, information
costs such as subscription to Reuter reports and news channels and
administrative costs of exposure management.
III. Factors affecting the decision to hedge foreign currency risk
Research in the area of determinants of hedging separates the decision of a firm
to hedge from that of how much to hedge. There is conclusive evidence to
suggest that firms with larger size, R&D expenditure and exposure to exchange
rates through foreign sales and foreign trade are more likely to use derivatives.
(Allayanis and Ofek, 2001)
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First, the following section describes the factors that affect the decision to hedge
and then the factors affecting the degree of hedging are considered.
 Firm size: Firm size acts as a proxy for the cost of hedging or economies of
scale. Risk management involves fixed costs of setting up of computer
systems and training/hiring of personnel in foreign exchange management.
Moreover, large firms might be considered as more creditworthy
counterparties for forward or swap transactions, thus further reducing their
cost of hedging. The book valueof assets is used as a measure of firm size.
 Leverage: According to the risk management literature, firms with high
leverage have greater incentive to engage in hedging because doing so
reduces the probability, and thus the expected cost of financial distress.
Highly levered firms avoid foreign debt as a means to hedge and use
derivatives.
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 Liquidity and profitability: Firms with highly liquid assets or high
profitability have less incentive to engage in hedging because they are
exposed to a lower probability of financial distress. Liquidity is measured by
the quick ratio, i.e. quickassets divided by current liabilities). Profitability is
measured as EBIT divided bybook assets.
 Sales growth: Sales growth is a factor determining decision to hedge as
opportunities are more likely to be affected by the underinvestment
problem. For these firms, hedging will reduce the probability of having to
rely on external financing, which is costly for information asymmetry
reasons, and thus enable them to enjoy uninterrupted high growth. The
measure of sales growth isobtained using the 3-year geometric average of
yearly sales growth rates.

Hedging Tools:
Hedging means reducing or controlling risk. This is done by taking a position in the
futures market that is opposite to the one in the physical market with the
objective of reducing or limiting risks associated with price changes.
It is a two-step process. A gain or loss in the cash position due to changes in price
levels will be countered by changes in the value of a futures position.
To Hedge or Not To Hedge?
Hedging has come into existence because of the prevalence of risks in every
business. These risks could be physical, operating and investment and credit risks.
Some of the risks such as the movements in commodity markets may be beyond
our control.
Hedging provides a means of managing such risks. The need to manage external
risk is thus one pillar of the derivative market. Parties wishing to manage their
risks are called hedgers.
Some people and businesses are in the business of taking risks to make money i.e.
the possibility of a reward. These parties represent another pillar of derivative
market and are known as speculators.
Some derivative market participants look for pricing differences and market’s
mistakes and takes advantage of these. These mistakes thus eventually disappear
and never become too large. Such participants are known as arbitrageurs.
By covering the currency commitment by derivative contracts, exporter/importer
needs no longer worry about the exchange risk element in the foreign
transactions.
Numerous studies have found that managing this risk can successfully reduce
your company’s foreign exchange exposure. Managing foreign exchange risk
provides the following benefits to many Canadian companies:
 minimize the effects of exchange rate movements on profit margins
 increase the predictability of future cash flows
 eliminate the need to accurately forecast the future direction of exchange
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rates
 facilitate the pricing of products sold on export markets

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 protect, temporarily, a company’s competitiveness if the value of the
Rupee rises (thereby buying time for the company to improve productivity)
Hedging Tools (Derivatives)
Introduction
The gradual liberalization of Indian economy has resulted in substantial inflow of
foreign capital into India. Simultaneously dismantling of trade barriers has also
facilitated the integration of domestic economy with world economy. With the
globalization of trade and relatively free movement of financial assets, risk
management through derivatives products has become a necessity in India also,
like in other developed and developing countries. As Indian businesses become
more global in their approach, evolution of a broad based, active and liquid
FOREX derivatives markets is required to provide them with a spectrum of
hedging products for effectively managing their foreign exchange exposures.
The global market for derivatives has grown substantially in the recent past. The
Foreign Exchange and Derivatives Market Activity survey conducted by Bank for
International Settlements (BIS) points to this increased activity. The total
estimated notional amount of outstanding OTC contracts increasing to $150
trillion at end−December 2009 from $94 trillion at end−June 2000. This growth in
the derivatives segment is even more substantial when viewed in the light of
declining activity in the spot foreign exchange markets. The turnover in traditional
foreign exchange markets declined substantially between 1998 and 2009. In April
2001, average daily turnover was $1,200 billion,compared to $1,490 billion in
April 1998, a 14% decline when volumes are measured at constant exchange
rates. Whereas the global daily turnover during the same period in foreign
exchange and interest rate derivative contracts, including what are considered to
be "traditional" foreign exchange derivative instruments, increased by an
estimated 10% to $1.4 trillion.
Evolution of the FOREX derivatives market in India:
This tremendous growth in global derivative markets can be attributed to a
number of factors. They reallocate risk among financial market participants, help

to make financial markets more complete, and provide valuable information to
investors about economic fundamentals. Derivatives also provide an important
function of efficient price discovery and make unbundling of risk easier. In India,
the economic liberalization in the early nineties provided the economic rationale
for the introduction of FX derivatives. Business houses started actively
approaching foreign markets not only with their products but also as a source of
capital and direct investment opportunities. With limited convertibility on the
trade account being introduced in 1993, the environment became even more
conducive for the introduction of these hedge products.
Hence, the development in the Indian FOREX derivatives market should be seen
along with the steps taken to gradually reform the Indian financial markets. As
these steps were largely instrumental in the integration of the Indian financial
markets with the global markets, the Indian economy saw a sea change in the
year 1999 whereby it ceased to be a closed and protected economy, and adopted
the globalization route, to become a part of the world economy. In the pre-liberalization
era, marked by State dominated, tightly regulated foreign exchange
regime, the only risk management tool available for corporate enterprises was,
‘lobbying for government intervention’. With the advent of LERMS (Liberalized
Exchange Rate Mechanism System) in India, in 1992, the market forces started to
present a regime with steady price volatility as against the earlier trend of long
periods of constant prices followed by sudden, large price movements.
The unified exchange rate phase has witnessed improvement in informational and
operationalefficiency of the foreign exchange market, though at a halting pace. In
the corporate finance literature, research on risk management has focused on the
question of why firms should hedge a given risk.
The literature makes the important point that measuring risk exposures is an
essential component of a firm's risk management strategy. Without knowledge of
the primitive risk exposures of a firm, it is not possible to test whether firms are
altering their exposures in a manner consistent with theory. Recent product
innovations in the financial markets and the use of these products by the
corporate sector are also examined. In addition to the traditional "physical"
products, such as spot and forward exchange rates, the new "synthetic" or
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derivative products, including options, futures and swaps, and their use by the
corporate sector is considered. These synthetic products have their market value
determined by the value of a specific, underlying, physical product. The spurts in
foreign investments in India have led to substantial increase in the quantum of
inflows and outflows in different currencies, with varying maturities. Corporate
enterprises have had to face the challenges of the shift from low risk to high risk
operations involving foreign exchange. There was increasing awareness of the
need for introduction of financial derivatives in order to enable hedging against
market risk in a cost effective way. Earlier, the Indian companies had been
entering into forward contracts with banks, which were the Authorized Dealers
(AD) in foreign exchange. But many firms preferred to keep their risk exposures
un-hedged as they found the forward contracts to be very costly. In the current
formative phase of the development of the foreign exchange market, it will be
worthwhile to take stock of the initiatives taken by corporate enterprises in
identifying and managing foreign exchange risk.
Risk Management Tools Available in India:
A derivative is a financial contract whose value is derived from the value of some
other financial asset, such as a stock price, a commodity price, an exchange rate,
an interest rate, or even an index of prices. The main role of derivatives is that
they reallocate risk among financial market participants,help to make financial
markets more complete. This section outlines the hedging strategies using
derivatives with foreign exchange being the only risk assumed. The FOREX
derivative products that are available in the Indian financial market are as follows:
 Forwards: A forward is a made-to-measure agreement between two
parties to buy/sell aspecified amount of a currency at a specified rate on
a particular date in the future. Thedepreciation of the receivable
currency is hedged against by selling a currency forward. If therisk is that
of a currency appreciation (if the firm has to buy that currency in future
say forimport), it can hedge by buying the currency forward. E.g. if RIL
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wants to buy crude oil in USdollars six months hence, it can enter into a
forward contract to pay INR and buy USD and lockin a fixed exchange
rate for INR-USD to be paid after 6 months regardless of the actual INR
Dollarrate at the time. In this example the downside is an appreciation
of Dollar which isprotected by a fixed forward contract. The main
advantage of a forward is that it can be tailoredto the specific needs of
the firm and an exact hedge can be obtained. On the downside, these
contracts are not marketable; they can’t be sold to another party when
they are no longerrequired and are binding.
Page55
Generally there are two types of Forward Contracts:
 Fixed Forward Contract:
The forward contract under which the delivery of foreign exchange
should take place on a specified future date is known as a fixed forward
contract.
It is further sub-divided into two:
1) Rupee Forward Contract
2) Cross Currency Forward Contract
 Option Forward Contract:
With a view to eliminate the difficulty in fixing the exact date for
delivery of foreign exchange, the customer may be given a choice of
delivering the foreign exchange during a given period of days.
“An arrangement whereby the customer can sell/buy from the bank
foreign exchange on any day during a given period of time at a
predetermined rate of exchange is known as an Option Forward
Contract.”
 Futures: A futures contract is similar to the forward contract but is more
liquid because it istraded in an organized exchange i.e. the futures
market. Depreciation of a currency can behedged by selling futures and
appreciation can be hedged by buying futures. Advantages offutures are

that there is a central market for futures which eliminates the problem
of doublecoincidence. Futures require a small initial outlay (a proportion
of the value of the future) withwhich significant amounts of money can
be gained or lost with the actual forwards pricefluctuations. This
provides a sort of leverage.The previous example for a forward contract
for RIL applies here also just that RIL will have togo to a USD futures
exchange to purchase standardized dollar futures equal to the amount
tobe hedged as the risk is that of appreciation of the dollar. As
mentioned earlier, the tailor abilityof the futures contract is limited i.e.
only standard denominations of money can be boughtinstead of the
exact amounts that are bought in forward contracts.In India, Currency
Futures in INR is not available otherwise in world FOREX market; all
major currency futures are available. Currency futures are traded on
futures exchange and the most popular exchanges are the ones where
the contracts are transferable freely. The Singapore International
Monetary Exchange (SIMEX) and the International Monetary Marker,
Chicago (IMM) are the most popular futures exchanges. The main
currencies traded on the exchanges are Japanese Yen, Pound Sterling,
Swiss Franc, Australian Dollar and Canadian Dollar.
Page56
 Options: A Currency Option is a contract giving the right, not the
obligation, to buy or sell aspecific quantity of one foreign currency in
exchange for another at a fixed price; called theExercise Price or Strike
Price. The fixed nature of the exercise price reduces the uncertainty
ofexchange rate changes and limits the losses of open currency
positions. Options areparticularly suited as a hedging tool for contingent
cash flows, as is the case in biddingprocesses. Call Options are used if
the risk is an upward trend in price (of the currency), whilePut Options
are used if the risk is a downward trend. Again taking the example of RIL
whichneeds to purchase crude oil in USD in 6 months, if RIL buys a Call
option (as the risk is anupward trend in dollar rate), i.e. the right to buy
a specified amount of dollars at a fixed rate ona specified date, there are

two scenarios. If the exchange rate movement is favorable i.e. thedollar
depreciates, then RIL can buy them at the spot rate as they have
become cheaper. Inthe other case, if the dollar appreciates compared to
today’s spot rate, RIL can exercise theoption to purchase it at the agreed
strike price. In either case RIL benefits by paying the lowerprice to
purchase the dollar.
Generally, there are two types of Options:
(1) Cross Currency Options:
The RBI has permitted authorized dealers to offer cross currency options to
the corporate clients and other interbank counter parties to hedge their
foreign currency exposures. Before the introduction of these options, the
corporate were permitted to hedge their foreign currency exposures only
through forwards and swaps route. Forwards and swaps do remove the
uncertainty by hedging the exposure but they also result in the elimination
of potential extraordinary gains from the currency position. Currency
options provide a way of availing of the upside from any currency exposure
while being protected from the downside for the payment of an upfront
premium.
Page57
(2) Rupee Currency Options:
Introduction of USD-INR options would enable Indian FOREX market
participants manage their exposures better by hedging the Dollar-Rupee
risk. The advantages of currency options in Dollar-Rupee would be as
follows:
 The nature of the instrument makes its use possible as a hedge
against uncertainty of cash flows. Option structures can be used to
hedge the volatility along-with the non-linear nature of pay-offs.
 Hedge for currency exposures to protect the downside while
retaining the upside by laying a premium upfront. This would be a big
advantage for importers, exporters as well as businesses with
exposures to international prices.
 Swaps: A swap is a foreign currency contract whereby the buyer and
seller exchange equalinitial principal amounts of two different

currencies at the spot rate. The buyer and seller exchange fixed or
floating rate interest payments in their respective swapped currencies
overthe term of the contract. At maturity, the principal amount is
effectively re-swapped at apredetermined exchange rate so that the
parties end up with their original currencies. Theadvantages of swaps
are that firms with limited appetite for exchange rate risk may move to
apartially or completely hedged position through the mechanism of
foreign currency swaps,while leaving the underlying borrowing intact.
Apart from covering the exchange rate risk,swaps also allow firms to
hedge the floating interest rate risk. Consider an export
orientedcompany that has entered into a swap for a notional principal
of USD 1 million at an exchangerate of 42/dollar.The company pays US
6months LIBOR to the bank and receives 11.00% p.a. every 6 monthson
1st January & 1st July, till 5 years. Such a company would have earnings
in Dollars and canuse the same to pay interest for this kind of borrowing
(in dollars rather than in Rupee) thushedging its exposures.
Page58
 Foreign Debt: Foreign debt can be used to hedge foreign exchange
exposure by takingadvantage of the International Fischer Effect
relationship. This is demonstrated with theexample of an exporter who
has to receive a fixed amount of dollars in a few months frompresent.
The exporter stands to lose if the domestic currency appreciates against
that currencyin the meanwhile so, to hedge this; he could take a loan in
the foreign currency for the sametime period and convert the same into
domestic currency at the current exchange rate. Thetheory assures that
the gain realized by investing the proceeds from the loan would match
theinterest rate payment (in the foreign currency) for the loan.

Other Hedging Instruments:
Hedging FX exposure is possible with a range of internal and external methods.
– Internal methods can be utilized to manage FX risk from within the company
or between related companies without the use of external market
instruments→ operating and financial hedges (also natural hedge).
Internal methods:
Page59
 Invoice in home currency
One easy way is to insist that all foreign customers pay in your home
currency and that your company pays for all imports in your home
currency.
However the exchange-rate risk has not gone away, it has just been
passed onto the customer. Your customer may not be too happy with
your strategy and simply look for an alternative supplier.
Achievable if you are in a monopoly position, however in a competitive
environment this is an unrealistic approach.
 Leading and lagging
If an importer (payment) expects that the currency it is due to pay will
depreciate, it may attempt to delay payment. This may be achieved by
agreement or by exceeding credit terms.
If an exporter (receipt) expects that the currency it is due to receive will
depreciate over the next three months it may try to obtain payment
immediately. This may be achieved by offering a discount for immediate
payment. The problem lies in guessing which way the exchange rate will
move.
 Matching
When a company has receipts and payments in the same foreign
currency due at the same time, it can simply match them against each
other.
It is then only necessary to deal on the FOREX markets for the
unmatched portion of the total transactions. An extension of the
matching idea is setting up a foreign currency bank account.

Page60
 Decide to do nothing?
The company would "win some, lose some". Theory suggests that, in the
long run, gains and losses net off to leave a similar result to that if
hedged.
In the short run, however, losses may be significant. One additional
advantage of this policy is the savings in transaction costs.
– External methods refer to hedging methods available to the company
externally (on the market) in the form of specialized hedging instruments→
contractual hedges.
External methods:
 Short Term Borrowing
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. The cost of this money market hedge is the interest
differentials between the two countries. The money market hedge suits
many companies because they have to borrow anyway, so it is simply a
matter of denominating the company’s debt in the currency to which it
is exposed.
 Discounting
Discounting can be used to cover only the export receivables. It cannot
be used to cover foreign currency payables or to hedge a translation
exposure. Where an export receivable is to be settled by bill of
exchange, the exporter can discount the bill any time and receive the
payment before the receivable settlement date. The bill may be
discounted either with the foreign bank in the customer’s country in
which case the foreign currency proceeds can be repatriated
immediately or with the exporter’s country bank at the currency spot
rate.
 Factoring

Factoring can only be used as a means of covering export receivables.
When the export receivable is to be settled on open account, rather
than by bill of exchange, the receivables can be assigned as collateral for
selected bank financing. Under most circumstances, such service will
give protection against rate changes, though during unsettled periods in
the foreign exchange markets, appropriate variations may be made in
the factoring agreement.
Page61
 Government Exchange Risk Guarantees
To encourage exports, government agencies in many countries offer
their exporters insurance against export, credit risk and special export
financing schemes.

Page62
Foreign Exchange Risk Management at Rolex:
Rolex Rings Pvt. Ltd. being the largest producer of hot forged rolled rings in India
along-with finished machining through CNC route is bound to have a good
amount of import-export of its own. According to the company sources, out of
the total sales of the company, 70% comprises that of the exports and the
remaining 30% is that of the domestic sales.
The company in order to carry out its production activity does import a part of its
raw materials from the foreign countries. It also has a set of huge imported
machineries purchased from countries like Japan, Germany etc. Some of the
specialized services too are being imported by the firm for its facilitation.
So in order to manage these kinds of transactions, a company like Rolex Rings is
bound to have a proper FOREX management system so as to generate profits. The
absence of this kind of a system will ultimately lead to losses which will affect the
company in many different ways.
At Rolex Rings, the firm uses the following techniques for the imports and
exports:
For Exports:
 Discounting the Bill of Exchange:
A non-interest-bearing written order used primarily in international
trade that binds one party to pay a fixed sum of money to another party
at a predetermined future date.
Bills of exchange are similar to checks and promissory notes. They can
be drawn by individuals or banks and are generally transferable by
endorsements. The difference between a promissory note and a bill of
exchange is that this product is transferable and can bind one party to
pay a third party that was not involved in its creation. If these bills are
issued by a bank, they can be referred to as bank drafts. If they are
issued by individuals, they can be referred to as trade drafts.

As soon as the bill of exchange is accepted by the concerned party, the
bill is discounted by Rolex Rings from the bank. The bank is then liable to
pay the amount of export order to the firm based on the spot rate of the
currency in exchange market. After this, at the time of the maturity of
the bill, the bank will then collect the same amount of foreign currency
from the importer. However, though the amount of the foreign currency
will be the same, the rate of the same in INR at that point of time may
be different i.e. high or low.
Let us take an example to understand this in a better way.
Suppose on Jan 1, 2013 Rolex Rings received the bill of exchange of an
export order of amount 100000$ having a maturity period of 3 months.
Now for Rolex, it can wait till 3 months or else it can get it discounted.
So the firm goes with the discounting from the bank. On that particular
day, the spot rate of the USD/INR = Rs.50. thus, the bank will now pay
the firm with 100000*50= Rs.5000000.
Now on Mar 31, 2013 i.e. the maturity date, the bank will collect the
100000$ from the importer. Turns out that the USD/INR rate on that day
was Rs.52. As a result, the bank will be receiving 100000*52 =
Rs.5200000 from the importer. There can be altogether a completely
opposite situation too, whereby the bank might have to bear some loss
because of the reduced USD/INR rate.
Rolex Rings has its deals with two types of currencies in its export orders. They
are:
Page63
1) US Dollar
2) Euro
For Imports:
Import of Raw Materials and Components
 Forward Contracts:

Forward exchange contract is a device which can afford adequate
protection to an importer or an exporter against exchange risk. Forward
currency contracts are most widely used tools for foreign exchange risk
management.
Rolex Rings uses the forward contracts in the import of its raw materials.
In this case, during the time of purchase a specific payment rate is fixed
which the firm will be liable to pay at time of final payment. This rate is
known as the forward rate. Generally they will be having a time period
of 1, 2 or 3 months. The rate fixed at present day will be the rate that
the firm will be paying at time of maturity. If at the time of maturity,
there arises a difference in the pre-determined value and the current
value, then also the firm will be giving the pre-determined rate only.
Thus, for an import order of 100000$ with a maturity date of 1 month
and the forward rate of Rs.52, even though at the time of maturity the
spot rate turns out to be Rs.53, Rolex Rings will be liable to pay
100000*52= Rs.5200000 only and not 100000*53 = Rs.5300000.
Page64
Import of Services
 Spot Rates:
Now as far as the imports of services are concerned, the amount that
Rolex Rings is liable to pay is based on the spot rate and not the forward
rate. Herein, as soon as the bill is received by the firm, based on that
taking into accounts the current market rates, the payment is carried
out to the exporter.
Rolex Rings has its deals with the following currencies in the import orders:
1) US Dollar
2) Japanese Yen
3) Canadian Dollar

Page65
4) Swish Franc
Here is the table showing the details of the import, export and consumption of
Rolex Rings for years 2010-11, 2011-12 and 2012-13.
(Rs. In Million)
Year
2010-11 2011-12 2012-13
Imports Purchase
Raw Materials 929.19 1263.84 1258.61
Spare Parts 23.57 27.02 3.22
Capital Goods 429.04 265.48 37.77
Consumption
Imported
Raw Materials 730.75 1599.15 1465.73
Components 27.79 28.6 25.39
Indigenous
Raw Materials 1233.92 980.13 1363.06
Components 199.56 411.41 301.06
Sales
Export 1679.99 2230.63 2481.31
Domestic 1456.96 1918.489 1691.06
Scrap 176.394 366.22 324.635

Findings - Conclusion:
With reference to the study undertaken with help of the secondary data, some of
the key findings and conclusion related to that of the Rolex Rings are as follows:
 The firm is having an effective FOREX management system.
 The firm is satisfied with the bill discounting it follows for the exports
Page66
and forward contracting for imports.
 The firm being a medium scale industry, it faces transaction exposure.
 There are no problems as such in the collection and payment of
amounts.
 The firm is not interested in adapting any other technique for the
import-exports.
 The firm is also flexible in different currency dealings in case of imports.
 Also, the firm does not believe in speculation as it is the most risky
technique and least favored by others too.

Page67
Bibliography:
 Book:
Foreign Exchange and Risk Management, C.Jeevanandam – Sultan Chand &
Sons
 Newspapers:
The Economic Times
Business Standard
 Research Article:
Hedging of Foreign Exchange Risk by Corporate in India, Dr. HirenManiar
 Websites:
www.rbi.org.in
www.fedai.org.in
www.x-rates.com
www.nseindia.com
www.rolexrings.com

“Foreign Exchange Risk Management” at Rolex Rings Pvt. Ltd., Rajkot

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“Foreign Exchange Risk Management” at Rolex Rings Pvt. Ltd., Rajkot