Currency Risk Management in Indian Banks

Currency venture Management in Indian negativeking companysEXECUTIVE SUMMARYThe objective of the invent is to study the attitude of Indian corpo range towards cash in happen management and the problems confront by the companies consumeing with their money flick which occur as a result of exports or substances or both. The study has withal included the problems face by the banks, the authorised dealers of alien transfigure in India, in managing their forex ( distant fill in) merchandise work as it has blown-up implication on the corpo s curio coin delineation.Indian corpo valuates sop up an attitude of staying impertinent from the bills commercializeplace place. Companies meet hedging as unwanted cost centres. Periods of ex tilt post stability bred complacency. Importers be confident that the Central banks shall intervene to halt any rupee worsening where a exporters atomic number 18 of the view that rupee has always been over localized and that on that point is no way that it shall appreciate from the present evaluate. These reason keep them away from hedging their picture shows.Companies which be manifold in hedging, go the conservative and Orthodox way to hedge their exposure. Not a single lodge surveyed, stock pecuniary differential coefficients other than send on contracts as neb for hedging their exposure. This is primarily beca recitation of wish of awareness and experience. Many of the companies feel that the importance of bills gamble management go prohibited add, in coming social classs notwithstanding unquestionablely few of them are devising themselves ready to face the situation.Banks that act as facilitators are as well as suffering from acute problems. Public welkin banks, which go over 75% of Indian forex tradeplace, pay off always been low staffed and governed by bureaucratic rules.The market for derivatives other than advancing contracts is in truth sh leave. Many of the banks re ason it step up to be as a result of corporeal reluctance and lack of information and technology. Most of the banks in public sector do non merge the forex and silver operation and they do non treat their forex operation as a sepa stray arrive at centre. This bred inefficiency in their operative which has bear upon the corpo vagabond sector.The corpo rank have been recommended to look st identifygi send fory into their exposure and constrict careful decision in hedging. This decision should be backed by master key treasurers, an efficient back office and good forecasting techniques. They have been asked to go in for various(a) other derivatives that are flexible and cost effective. The banking sector has been recommended to recruit specialised personnel for the job with latest technology to deal in the market. They should start providing variety of other derivatives to the industry. They should also merge their money market and forex operation and treat is as a separate profit centre.These all bank bills bequeath definitely make the forex market deep and vibrant, which will make the work easier for corporates in dealing with the bullion exposure.1. INTRODUCTIONWe have to sleep with one eye openManaging director of an Indian company with investments in Indonesia.This was in reference to the Indonesian rupiah crash which followed the nearly one hundred percent, Thai funds plunge after the bahts free float stomach July with the Indonesian silver in belt downward spiral and by-line rates shooting northwards, Indian companies with investment in South-east Asia are in the midst of the maelstrom and are desperately scrambling to get a wait of this unprecedented situation even as they wonder what neighboring?If provided they could have got the wind of the disaster things would have been bit different for them. The multitude of Southeast Asian bills plunge has sent warning signals to the ontogeny economies to grade down their level in sta te to face crisis.Companies have to set their house in order and give a micro as well as macro look at the currency exposure which they are facing. With addition in volume of business in foreign sector, companies should make themselves tuned to the dynamics of hostile alternate (currency) market.1.1 Currency RISK precautionAn asset or a liability or an expected emerging cash flow stream (whether certain or non) is said to be afflicted with currency risk when currency set offment qualifyings (for better or for worse) the seat currency value.There is always a possibility of the alter rate changing between the home and foreign currencies, interestingness rate differentials widening and pomposityary effects amounting, to an adverse reaction for the expected cash flows . The concept of currency risk also emanates when an investor is planning to diversity his portfolio internationally to improve the risk- return trade off by pickings advantage of the relative correlation a mong risks on assets of different countries. This involves investing in a variety of currencies whose relative determine whitethorn fluctuate , it involves taking currency risks.The foreign switch over market is psychological in disposition. A large occur of proceedings are speculative in spirit which depends upon expectations of a large number of participants.People tend to hitch their expectations to one fundamental.For example, they superpower look at the money supply in the USA. The logic is that an change magnitude in money supply will result in An increase in inflation FED squeezing money Interest rate rising Dollar becoming more(prenominal) attractive for holding.But this gist of money supply could also lead to a different serial publication of outcomes an shown by the following logic.According to fisherman equation,Nominal rate = objective rate + Inflation rate. An increase in inflation would mean the interest rates would be higher(prenominal). Higher interest ra tes on adherence and equity prices would make them less lucrative and thus lead to a bearish effect. There would be a selling pressure on the dollar and hence the turn rates would tend to move against the dollar. dealing in foreign veer market is said to be about $ 1000 billion each day. Out of this sizeable chunk of more than 75% is on speculative basis. And this speculation has been pointed out as study cause of the south Asian turmoil.Since the mid 1970s a secure mix of fast-inter throw outing market and a revolution in information technology has increased the speed, frequency and magnitude of price changes in the financial markets, which, in turn have multiplied both opportunity and risk for the CFO.Not, surprisingly, in the developed markets, much innovative energy has been devoted to devising instruments and mechanisms that modify CFO to survive this turbulence. While creative financial engineering has receptive the floodgates for a deluge of products, two spacious cleares of risk management have evolved.The first deploys a natural hedge to manage exposure to risk. Typically, this direction explicitly factoring in risk perceptions when choosing the components of the financing mix. Or, to neutralise exposures in a particular market, a natural hedge could involve taking a counter position in another market. The second class of tools however creates a synthetic hedge by utilising specific financial instruments. Notably, derivatives.1.2 Problems in Indian foreign win over marketOur foreign transform market suffers from several constraints.i) There are a lot of ceilings on open positions and gaps and hence on that point is a virtual absence of market making and position trading.ii) There is prohibition of initiating consummations in the corrupt currency in the overseas market.iii) Besides the anterior contracts, at that place is no free access to the other products alike futures, swaps, etc. The market lacks the command liquidity and dept h for the derivatives to be economically viable.2. Literature review2.1 THE temper OF EXPOSURE AND RISKThe value of a watertights assets, liabilities and in operation(p) income vary continually in response to changes in economic and financial variables such as exchange rates, interest rates, inflation rates, relative prices and so forth. The come to of all financial decision on the value of the substantial is uncertain and various options washbowl be evaluated in call of their risk return characteristics.The nature of skepticism bunghole be illustrated by a number of normally encountered situations. An appreciation of the value of a foreign currency (or equivalently, a depreciation of the national currency)., increases the municipal currency value of a firms assets and liabilities denominated in the foreign currency receivable and payables, bank deposits and loans etc. It will also change domestic currency cash flows from exports and imports. An increase in interest ra tes reduces the market value of a portfolio of fixed rate bonds and whitethorn increase the cash outflow on account of interest payments. Acceleration in the rate of inflation may increase the value of unsold stocks, the tax income from future sales as well as the future be of production. gum olibanum the firm is exposed to uncertain changes in a number of variables in its environment.Let us begin with the description of foreign exchange exposure. strange exchange (Currency) exposure is the sensitivity of the real value of a firms assets, liabilities or operating income, expressed in its functional currency, to un evaluate changes in exchange rates.Note the following important points about this definition.Values of assets, liabilities or operating income are to be denominated in the functional currency of the firm. This is the elemental currency of the firm and in which its financial statements are produce. For most firms it is the domestic currency of their plain.Exposure i s defined with respect to the real values i.e. values adjusted for inflation. While theoretically this is the correct way of assessing exposure, in praxis due to the difficulty of dealing with an uncertain inflation rate this appointment is often ignored i.e. exposure is estimated with reference to changes in nominal values.The definition stresses that only unanticipated changes in exchange rates are to be considered. The reason is that markets will have already made an allowance for anticipated changes in exchange rates. For instance, an exporter invoicing a foreign buyer in the buyer currency into the price. A lender will adjust the rate of interest charged on the loan to incorporate an allowance for the expected depreciation. From an operating(a) point of view, the question is how do we separate a given change in exchange rate into its anticipated and unanticipated components since only the actual change is observable? One possible answer is to use the send on exchange rate as the exchange rate expected by the market to rule at the time the front contract matures. Thus bet that the price of a chew sterling in terms of rupees for nimble delivery (the called posture rate) is Rs. 60.000 while the one months send on-moving rate is Rs. 60.20. We can say that the anticipated depreciation of the rupee is 20 paise per whip in one month. If a month later, the spot rate turns out to be Rs. 60.30 there has been an unanticipated depreciation of 10 paise per pound.In line to exposure which is a measure of the response of value to exchange rate changes, foreign exchange risk is defined as.The variance of the real domestic currency value of assets, liabilities or operating income attribute to unanticipated changes in exchange rates.In other words, risk is a measure of the effect of variability in the values of assets etc. due to unanticipated changes in exchanges rates.2.2 Classification of Foreign counterchange Exposure and RiskThree types of foreign exchang e exposure and risk can be distinguished depending upon the nature of the exposed item and the purpose of exposure estimation. These are as follows. feat ExposureThis is a measure of the sensitivity of the home currency value of assets and liabilities which are denominated in foreign currency, to unanticipated changes in exchange rates, when the assets or liabilities are liquidated.Transaction exposure can arise in tether ways* A currency has to be converted in order to make or bugger offd payment for good s and services.* A currency has to be converted to repay a loan or make an interest payment (or, conversely, receive a repayment or an interest payments) or.* A currency has to be converted to make a dividend payment.Suppose a firm receives an export order. It fixes a price, manufactures the product, makes the shipment and gives 90 days credit to the buyer who will pay in his currency. A company has acquired a foreign currency receivable, which will be liquidated ahead the next counterbalance sheet date. The exposure affects cash flows during the trustworthy story pointedness. If the foreign currency has appreciated between the day the receivable was book on the day the payment was received, the company makes exchange gain which may have tax implications. In a similar fashion, interest payments and whiz repayments due during the report period create transaction exposure. Transaction risk can be defined as a measure of uncertainty y in the value of assets and liabilities when they are liquidated. explanation Exposure in any cutting called chronicle Exposure is the exposure on assets and liabilities appearing in the balance sheet but yet to be liquidated. Translation risk is the colligate measure of variability.The key difference between transaction and translation exposure is that the former involves actual movement of cash while the latter has no direct effect on cash flows. (This is true only if there are no tax effects arising out of translatio n gains and losses).Translation exposure arises when a conjure multinational company is undeniable to unify a foreign subsidiarys statements from its functional currency into the parents home currency. Thus suppose an Indian company has a U.K subsidiary. At the beginning of the parents financial yr the subsidiary has real estate, inventories and cash valued at pound 1,000,000, pound 200,000 pound 150,000 respectively. The spot rate is Rs. 60 per pound sterling. By the most of the financial year, these have changed to pound 1,200,000, pound 205000 and pound 160,000 respectively. However during the year, there has been a drastic depreciation of the pound to Rs. 56. If the parent is required to study the subsidiarys balance sheet from pound sterling into rupees at the current exchange rate, it has suffered a translation loss. Note that no cash movement is elusive since the subsidiary is not to be liquidated. Also note that there mustiness have been a translation gain on the su bsidiarys liabilities.There is broad agreement among theorists that translation losses and gains are only risky accounting losses and gains. The actual numbers will differ according to the accounting practices followed and depending upon the tax laws, there may or may not be tax implications and therefore real gains or losses. Accountants and corporate treasurers however do not fully accept this view. They argue that even though no cash losses or gains are involved, translation does affect the published financial statements and hence may affect market valuation of the parent companys stock. Whether investors indeed suffer from translation illusion is an empirical question. Some severalise from studies of the valuation of American multinationals seems to indicate that investors are quite aware of the notional character of these losses and gains and discount them in valuing the stock. for Indian multinational, translation exposure is a relatively less important consideration since the law does not require translation and consolidation of foreign subsidiaries financial statement s with those of the parent companies.Operating ExposureUnanticipated exchange rate changes not only affect assets and liabilities but also have significant impact on future cash flows from operations. Operating Exposure is a measure of the sensitivity of future cash flow and profits of a firm to unanticipated exchange rate changes.Consider a firm that is involved in producing goods for export and or import substitutes. It may also import a part of its raw corporeals, components etc. A change in exchange rate (s) gives rise to a number of concerns for such a firm.1. What will be the effect on sales volume if prices are maintained? If prices are changed? Should prices be changed? For instance, a firm exporting to a foreign market might benefit from reducing its foreign currency price to the foreign customers following an appreciation of the foreign currency. A firm that produces import substitutes may contemplate an increase in it domestic currency price to its domestic customers without hurting its sales.2. Since a part of the inputs are imported, material costs will increase following a depreciation of the home currency.3. Labour costs may also increase if cost of donjon increases and wages have to be raised.4. Interest costs on working capital may rise if in response to depreciation the authorities resort to mo send awayary tightening.In general, an exchange rate change will affect both future revenues as well as operating costs and hence the operating income. As we will see later, the net effect depends upon the complex interaction of exchange rate changes, relative inflation rates at home and abroad, price elasticities of export and import penury and supply and so forth. Operating exposure and the related risk are extremely difficult to analyse, estimate and hedge against.2.3 THE INDIAN FOREX food marketIndian foreign exchange market as compared with thei r American and European counterparts is till in its infants. The post relaxation period has witnessed some exchange controls been get up and introduction of few hedging tools like cross currency option, represent forwards, currency swaps etc. which provide a degree of flexibility to corporates in using the forex markets effectively. The rupee has been made fully convertible on current account accepting the article VIII status laid down by IMF. This step has seen increased volume of trade in the Indian forex market.Tarapore committee has put the proposal for capital account convertibility. It proposes to deregulate the foreign exchange by year 2002 in three phases.2.4 PRESENT berthExchange control in India is administered by the Reserve Bank of India, which is charge by the Foreign exchange regulation Act. The figure shows the players involved in the foreign exchange market from administrative point of view.Foreign ExchangeRegulation Act, 1973Govt. of IndiaReserve Bank of Indi aForeign Exchange DealersAssociation of India appoint DealersAuthorised MoneyChangersFull Fledged RestrictedAdministration of Foreign Exchange in India.The foreign exchange market in India functions with a three-tier structure which includes (1) Reserve Bank of India, at the apex level, (ii) authorised dealers/money changers conducting foreign exchange trading activities, and (iii) customers which include exporters/importer, corporates and other foreign exchange earners like NRIs etc.The market is highly influenced by State Bank of India and Reserve Bank of India because of their Sheer Size. The run batted in constantly intervenes to keep the rupee from appreciating and is responsible for highly liquid spot market as it is a last resort buyer of dollars.The forward market in India is passably liquid and quotes are easily available up to sixer months. The RBI prohibits any international speculative access to rupee.2.5 SIZE AND DEPTH OF THE MARKETThe daily turnover in the Indian For eign exchange market is over US $400 million that is dominated by dealings in dollars. The foreign exchange reserve of $30 million provides the market with enough liquidity.2.6 INDIAN EXCHANGE CONTROLSExchange Controls refer to the regulation, restrictions, guidelines that a country issues with respect to foreign exchange transactions. In the absence of any exchange control one would expect to do anything with the foreign exchange militia that the company has-convert to any other currency, speculate, buy or sell option, freely export foreign exchange etc. etc.In India, forward contract is the single largest product which the companies employ as a tool to manage their foreign exchange risks, though the cost has changed over the period of time. Before LERMS (liberalised exchange rate management system) importers rushed to book forward contracts expecting a devaluation of Re against US$. The cost was as high as 18% in Feb.92. The cost of the forward exchange agio came down precipit ously reflecting a more stable foreign exchange markets.The Indian exchange market do not provide frequent quotations for ore than 6 months so for any long term forward cover rollover of the contract after every 6 months is needed. Rollover means cancellation of the old contract and re- fight of 6-month forward contract. on a lower floor this, care should be taken to cancel the old contract and re-book the next at the time when the cost of rebooking is least i.e. forward dollar is relatively cheap.Further, in celestial latitude 1994, RBI has allowed the corporates to bet on the third currency movement even if one does not have an profound transaction exposure in the third currency. This means that a corporate with an underlying exposure in Dollar-Re can bet on the Dm-Dollar rate and book a forward contract for Dm against Re and on the maturity may change Dm to Dollar at the spot rate. This has been allowed as Indian Re has been pegged with US$ and there has not been many fluctuat ions on which the companies could speculate. There can be other ways to take advantage of this RBI circular. Consider an importer with $ payable after 6 months. He may buy $ forward against Yen (third currency) and after 6 months may buy Yen against Rupee at the spot rate. This position may be taken if the company expects Yen to underrate against the Dollar inwardly these 6 months. Nevertheless the speculative attempts to earn profits may also backfire to give losses if the exchange rate moves in the turnabout direction. RBI has also made it obligatory upon the banks, which extend the third currency cover, to maintain initial and variation margins sooner offering such a facility. This has been done to avoid any default risk.Another peculiar cause of The Indian Exchange Control is that the hedging can be put through in case of transaction and translation exposures only. Economic exposures cannot be hedged. tail Currency option was introduced on 1st Jan. 1994, under which compani es could show option contract for hedging non-dollar exposure against dollar. As for now Rupee option does not exist in India. Essar Gujarat has been one of the innovative corporates who ascertained this new concept and has benefited considerably by writing option in Dm- Dollar in Jan 1994. Indian Exchange controls do not allow cancellation of cross currency options in parts and once the option is sour it cannot be re-booked, unlike forwards. In the overseas markets minimum lot traded is $ 3m whereas Indian corporate by for lesser amount, this increases the subsidy paid by them for the option. Recently, ANZ Grindlay has offered to place a loan of $ 50m to Ranbaxy by making effective use of call and put options to defend both the parties against unfavourable movements in exchange rates.Cross currency forward cover for importers who have taken $ loan for their imports but receive goods invoiced in say a Dm. They can enter forward cover for the delivery of Dm against the currency o f loan i.e. -$. This is the cross currency forward cover.Some of the foreign Exchange controls are that export of foreign currency is not permitted, unless it has special RBI permission. Exchange controls also they run the permitted currency and a method of payment as approved by RBI for translation across the countries. It also contains guidelines relating to Foreign currency assets lotion permission as for repatriation of capital profits dividends etc. Exchange controls also allow FC to be retained up 50% (in case of EOU EPZ units) and 25% (in case of ordinary exporters with banks in Indian and also abroad under EEFC a/c and FCA a/c. Exchange controls also state under-invoicing and over-invoicing of exports as a crime attracting penal provisions. Further, all sale proceeds in FC should come into the country within 180 days. RBI permission is required for any extension beyond 180 days. In case of failure to get RBIs nod, the tax and other export incentives are not provided to t he exporters.Further, exchange controls give details and guidelines for different accounts for NRI and foreign investors such as mine run Non- Resident Rupee a/c, Non-Resident External Rupee a/c FCNR (B) a/c etc.Introduction of complex hedging tools like futures, options is still a long way to go, Recently, the government lifted the ban on futures, option trading in equity (stocks) after 40 years, This could be regarded as a step ahead to come encompassing(prenominal) to introduction of more complex tools in the currency markets in India. In the near future Standard Chartered plans to introduce rupee-based derivatives in India humble to the clearance and approval by exchange controls, with many companies now making use of different tools effectively, the Indian foreign exchange markets are paltry ahead towards more relaxations and towards making the foreign exchange markets more vibrant and versatile, IDBI is one of the most active user of financial derivatives in Indian market. It made considerable savings over the last two year by using the entire range of products available in Indian forex markets.2.7 FINANCIAL DERIVATIVES USED IN INDIAN MARKETA derivative instrument is commonly defined as one whose price is derived from an underlying quantity that could be an interest or an exchange rate (in this case exchange rate) we refer to derivatives of money and foreign exchange market prices as financial derivatives.The history of using financial derivatives to hedge foreign exchange exposures by corporates in India is fairly recent. Early 90s witnessed few foreign currency call options written by some Indian corporates. The limited use and general lack of interest in the available instruments can be explained by the fact that dependence on external sources of funding was very limited and the external sector wasnt really developed.But after liberalisation and current account convertibility, the whole scenario has changed. Risk management has under gone(p) a pa radigm shift, new financial derivatives have been allowed in the market to provide for exposures arising out of increased business activity in the external sector. We shall discuss the various hedging tools is operative.2.7.1 forrad CONTRACTSThe Definition A forward contract is simply an agreement to buy or sell foreign exchange at a stipulated rate at a qualify time in the future. It is a contract calling for settlement beyond the spot date. The time frame can vary from a few days to many years.Instrument A forward contract twines you to a particular exchange rate, thereby insulating the CFO from exchange rate fluctuations. In India, the forward contract has been the most popular instrument employed by corporates to cover their exposures, and thereby, offset a known future cash outflow. prior contracts are usually available only for periods up to 12 months. anterior premiums are governed purely by demand and supply, which provide corporates with arbitrage opportunities. The pr emiums in this market are quoted till the last working day of the month.Internationally, the forward premiums or discounts reflect the prevailing interest rate differentials. Arbitrage opportunities are therefore limited. As a rule, a currency with a higher interest rate trades at a discount to a currency with a lower interest state. Since there is a forward market available for longer periods, the forward cover for foreign exchange exposures can stretch up to five years. The premiums or discounts are quoted on a month-to-month basis. That is, from the spot date to exactly one month, or two months, or even a year. AN EXAMPLE.A corporate has to make a payment of US $I million on March 31, 1998. They can book a forward contract today, and fix the exchange rate at which he will make the payment. Assuming that the dollar-rupee spot rate is Rs 36.40, and the forward premium on the dollar for delivery on March31. 1998, is Rs 0.30 the effective exchange rate for the remittance becomes Rs 3 6.70 (36,40+30).The Regulations In March 1992, in order to provide operational freedom to corporates, the unrestricted booking and cancellation of forward contracts, for all genuine exposures, whether trade-related or not, was permitted.In January 1997, the RBI allowed the banks to quote rupee forward premiums for more than six months. This has resulted in the development of a local forward market for up to one year. However, as the link between the local money market and the foreign exchange markets is not strong, and as prices and determined by demand and supply, activity in the long -term forward market has been limited.2.7.2 FORWARD TO FORWARD CONTRACTSThe Definition A forward -to-forward contract is a swap transaction that involves the simultaneous sale and purchase of one currency for another, where both transactions are forward contracts. It allows the company to take advantage of the forward premium without locking on to the spot rate. The Instrument A forward-to-forward con tract is a perfect tool for corporates that want to take advantage of the opposite movements in the spot and the forward markets. By locking in the forward premium at a high or low level now, CFOs can defer locking on to the spot rate to the future when they consider the spot rate to be moving in their favour.However, a forward-to forward contract can have serious cash-flow implications for a corporate. Before booking a forward-to forward contract a CFO should carefully determine his cash flow position bearing in mind the immediate loss that he would make if the spot rate did not move in his favour.The Example. An exporter believes that forward premiums are high, and will move down before the end of December 1997. Also he expects the spot rate to depreciate in the next few months. Then, the optimal strategy would be to lock in the high forward premium now, and defer the spot rate to a future date. So, he opts for a forward-to forward contract for end December. 1997, to end March of 1998. Paying a premium of say a Rs 0.64 By entering into such a contract the exporter has the opportunity to lock on to the spot rate any time till December 31, 1997. Alternatively, if the three-month premium between end-December and end-March moves below the Rs 0.64 level he can cancel the contract and book his profits.Forward -to-forward contractsThe SCenarioCompany A is due to receive the payment for goods exported three months earlier. Currently, three-month forward premiums are high, but Company A expects the sport rate to depreciate further.The InstrumentThe forward-to-forward pay-off matrixDSEFDSEFLack in the Current Premium By Purchasing A Forward-To-Forward Contact EFSF ameliorate Than Simple Forward, But Worse Than reveal strategyOptimal StrategyChoose The Spot Rate Within A Stipulated Time-Period, Thus ascertain Effective Forward RateSFEFWorst StrategyBetter than Uncovered Strategy,At the end of the months, Convert Export Proceeds to Rupee at the Effective Forward Rat e SF Simple Forward Rate EF Forward-to-Forwar