PROJECT REPORT ON

HEDGING OF FOREIGN EXCHANGE RISK BY CORPORATE IN INDIA

FOR THE PARTIAL FULFILLMENT OF THE REQUIREMENT FOR THE AWARD OF Master of business Administration (Mahamaya Technical University, NOIDA, Uttar Pradesh)

Submitted to: Dr. Bhupendra Gautam Designation: Assistant professor

Submitted by: Suhel yadav Roll No 11090770052 MBA 2011-13

Galgotias College of Engineering & Technology

1, Knowledge Park II, Greater Noida

Mahamaya Technical University, Noida

DECLARATION
I hereby declare that this project report Hedging the foreign exchange risk by corporate in India is my own work, to the best of my knowledge and belief. It contains no material previously published or written by another person nor material which to a substantial extent has been accepted for the award of any other degree or diploma of any other institute, except where due acknowledgement has been made in the text. Name: Suhel yadav Roll No:110977005 Institution Name: Galgotias college of Engineering and Technology

CERTIFICATE
Certify that Mr. Suhel yadav bearing Roll Number 1109770052 of MTU is a bonafide student of MBA 4th semester (2012-2013) at Galgotias College of Engineering & Technology, Greater Noida. He undertook Final Project titled Hedging the foreign exchange risk by corporate in India under the supervision and guidance of departmental faculty guide Dr. Bhupendra gautam in the partial fulfillment of the requirement of MBA program.

Faculty Supervisor

Director/HOD

ACKNOWLEDGEMENT

It is the great opportunity for me to write about subject like Hedging of Foreign Exchange risk by corporates in India. At the time of preparing this research report I went through different books and websites which help me to get acquainted with new topics. I am actually focusing on those topic which are important for us to understand about this subject easily. I acknowledge with gratitude to my faculty guide Dr. Bhupendra Gautam, who has always been sincere and helpful in making me understand the different system of legal research and conceptual problem in my report. Apart from me this report will certainly be immense importance for those who are interested to know about this topic. I hope the will find this comprehensible. I have tried hard and soul to gather all relevant documents regarding this subject. I dont know how far I am able to do that. Furthermore I dont claim that all the information in this report is included perfectly. There may be shortcoming, factual errors, mistaken opinions which all mine and I alone is responsible for those but I will try to give a better volume in future. Thank you Suhel yadav

LIST OF TABLES

TABLE NO 1 2 3 4 5

TABLE NAME

PAGE NO 69 70 71 91 96 99 133

Pros and cons of forward exchange contracts and options Pros and cons of other options Examples of possible strategies Outcome of hedging using currency options Possible cash flow outcome for hedging using outcomes Forward, Future, Options, and Gold Dinar as tools for managing forex risk: 6 comparison 7 Comparison of some of the internal foreign exchange techniques

TABLE OF CONTENTS

Acknowledgements List of Tables

i ii

S.NO

INDEX 1 INTRODUCTION 1.1 EVOLUTION OF THE FOREX DERIVATIVES MARKET IN INDIA 1.2 RBI (Reserve Bank of India) Regulations 1.3 FOREIGN EXCHANGE MANAGEMENT ACT, 1999 1.4 INTRODUCTION TO FOREX 1.5 CLEAR CONCEPT OF FOREIGN EXCHANGE 1.6 FOREIGN EXCHANGE EXPOSURES DEFINED 1.7 MANAGING FOREIGN EXCHANGE RISK 1.8 PROCESS & NECESSITY 1.9 FOREIGN EXCHANGE RISK MANAGEMENT FRAMEWORK 1.10 HEDGING STRATEGIES / INSTRUMENTS 1.11 CHOICE OF HEDGING INSTRUMENTS 1.12 CORPORATE HEDGING: TOOLS AND TECHNIQUES 1.13 HEDGING FOREIGN EXCHANGE RISK WITH DERIVATIVES AND THE GOLD DINAR: A
COMPARISON NOTE

PAGE NO. 6 7 13 14 41 48 60 65 73 76 79 81 84 89 101 109 109 110 115 116 126

1.14 HEDGE AGAINST EXCHANGE RATE RISK WITH CURRENCY ETFS 1.15 FOREIGN-EXCHANGE RISKS 2 3 4 5 6 LITERATURE REVIEW OBJECTIVES AND LIMITATIONS RESEARCH METHODOLOGY RESULTS AND FINDINGS CONCLUSION

BIBLIOGRAPHY

127

ABSTRACT
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 (Foreign Exchange) derivatives markets is required to provide them with a spectrum of hedging products for effectively managing their foreign exchange exposures. This research paper attempts to evaluate the various alternatives available to the Indian corporates for hedging financial risks. By studying the use of hedging instruments by major Indian firms from different sectors, the paper concludes that forwards and options are preferred as short term hedging instruments while swaps are preferred as long term hedging instruments. The high usage of forward contracts by Indian firms as compared to firms in other markets underscores the need for rupee futures in India. In addition, the paper also looks at the necessity of managing foreign currency risks, and looks at ways by which it is accomplished. A review of available literature results in the development of a framework for the risk management process design, and a compilation of the determinants of hedging decisions of firms.

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 endDecember 2009 from $94 trillion at endJune 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:

RISE OF DERIVATIVES: The global economic order that emerged after World War II was a system where many less developed countries administered prices and centrally allocated resources. Even the developed economies operated under the Bretton Woods system of fixed exchange rates. The system of fixed prices came under stress from the 1970s onwards. High inflation and unemployment rates made interest rates more volatile. The Bretton Woods system was dismantled in 1971, freeing exchange rates to fluctuate. Less developed countries like India began opening up their economies and allowing prices to vary with market conditions. Price fluctuations make it hard for businesses to estimate their future production costs and revenues. Derivative securities provide them a valuable set of tools for managing this risk. This section describes the evolution of Indian derivatives markets, the popular derivatives instruments, and the main users of derivatives in India. DEFINITION AND USES OF DERIVATIVES A derivative security is a financial contract whose value is derived from the value of something else, such as a stock price, a commodity price, an exchange rate, an interest rate, or even an index of prices. Derivatives may be traded for a variety of reasons. A derivative enables a trader to hedge some preexisting risk by taking positions in derivatives markets that offset potential losses in the underlying or spot market. In India, most derivatives users describe themselves as hedgers (Fitch Ratings, 2004) and Indian laws generally require that derivatives be used for hedging purposes only. Another motive for derivatives trading is speculation (i.e. taking positions to profit from anticipated price movements). In practice, it may be difficult to distinguish whether a particular trade was for hedging or speculation, and active markets require the participation of both hedgers and speculators. A third type of trader, called arbitrageurs, profit from discrepancies in the relationship of spot and derivatives prices, and thereby help to keep markets efficient. Jogani and Fernandez (2003) describe Indias long history in arbitrage trading, with line operators and traders arbitraging prices between exchanges located in different cities, and between two exchanges in the same city. Their study of Indian equity derivatives markets in 2002 indicates that markets were inefficient at that time. They
8

argue that lack of knowledge, market frictions and regulatory impediments have led to low levels of capital employed .Price volatility may reflect changes in the underlying demand and supply conditions and thereby provide useful information about the market. Thus, economists do not view volatility as necessarily harmful. Speculators face the risk of losing money from their derivatives trades, as they do with other securities. There have been some wellpublicized cases of large losses from derivatives trading. In some instances, these losses stemmed from fraudulent behavior that went undetected partly because companies did not have adequate risk management systems in place. In other cases, users failed to understand why and how they were taking positions in the derivatives in arbitrage trading in India. However, more recent evidence suggests that the efficiency of Indian equity derivatives markets may have improved (ISMR, 2004).

EXCHANGE-TRADED AND OVER-THE-COUNTER DERIVATIVE INSTRUMENTS OTC (over-the-counter) contracts, such as forwards and swaps, are bilaterally negotiated between two parties. The terms of an OTC contract are flexible, and are often customized to fit the specific requirements of the user. OTC contracts have substantial credit risk, which is the risk that the counterparty that owes money defaults on the payment. In India, OTC derivatives are generally prohibited with some exceptions: those that are specifically allowed by the Reserve Bank of India (RBI) or, in the case of commodities (which are regulated by the Forward Markets Commission), those that trade informally in havala or forwards markets. An exchange-traded contract, such as a futures contract, has a standardized format that specifies the underlying asset to be delivered, the size of the contract, and the logistics of delivery. They trade on organized exchanges with prices determined by the interaction of many buyers and sellers. In India, two exchanges offer derivatives trading: the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). However, NSE now accounts for virtually all exchange-traded derivatives in India, accounting for more than 99% of volume in 2003-2004. Contract performance is guaranteed by a clearinghouse, which is a wholly owned subsidiary of the NSE. 4 Margin requirements and daily marking-to-market of futures positions substantially reduce the credit risk of exchange- traded contracts, relative to OTC contracts.

DEVELOPMENT OF DERIVATIVE MARKETS IN INDIA Derivatives markets have been in existence in India in some form or other for a long time. In the area of commodities, the Bombay Cotton Trade Association started futures trading in 1875 and, by the early 1900s India had one of the worlds largest futures industry. In 1952 the government banned cash settlement and options trading and derivatives trading shifted to informal forwards markets. In recent years, government policy has changed, allowing for an increased role for market-based pricing and less suspicion of derivatives trading. The ban on futures trading of many commodities was lifted starting in the early 2000s, and national electronic commodity exchanges were created. In the equity markets, a system of trading called badla involving some elements of forwards trading had been in existence for decades. Exchange Board of India (SEBI) banned it for good in 2001. A series of reforms of the stock market between 1993 and 1996 paved the way for the development of exchange- traded equity derivatives markets in India. In 1993, the government created the NSE in collaboration with state-owned financial institutions. NSE improved the efficiency and transparency of the stock markets by offering a fully automated screen-based trading system and real-time price dissemination. In 1995, a prohibition on trading options was lifted. In 1996, the NSE sent a proposal to SEBI for listing exchange-traded derivatives. The report of the L. C. Gupta Committee, set up by SEBI, recommended a phased introduction of derivative products, and bi-level regulation (i.e., self-regulation by exchanges with SEBI providing a supervisory and advisory role). Another report, by the J. R. Varma Committee in 1998, worked out various operational details such as the margining systems. In 1999, the Securities Contracts (Regulation) Act of 1956, or SC(R)A, was amended so that derivatives could be declared securities. This allowed the regulatory framework for trading securities to be extended to derivatives. The Act considers derivatives to be legal and valid, but only if they are traded on exchanges. Finally, a 30-year ban on forward trading was also lifted in 1999. The economic liberalization of the early nineties facilitated the introduction of derivatives based on interest rates and foreign exchange. A system of market-determined exchange rates was adopted by India in March 1993. In August 1994, the rupee was made fully convertible on current account. These reforms allowed increased integration between domestic and international markets, and created a need to manage currency risk. Figure 1 shows how the volatility of the exchange rate between the Indian Rupee and the U.S. dollar has increased since 1991. 7 The easing of various restrictions on the free movement of interest rates resulted in the need to manage interest rate risk.

10

DERIVATIVES INSTRUMENTS TRADED IN INDIA In the exchange-traded market, the biggest success story has been derivatives on equity products. Index futures were introduced in June 2000, followed by index options in June 2001, and options and futures on individual securities in July 2001 and November 2001, respectively. stock indices. All these derivative contracts are settled by cash payment and do not involve physical delivery of the underlying product (which may be costly). Derivatives on stock indexes and individual stocks have grown rapidly since inception. In particular, single stock futures have become hugely popular, accounting for about half of NSEs traded value in October 2005. In fact, NSE has the highest volume (i.e. number of contracts traded) in the single stock futures globally, enabling it to rank 16 among world exchanges in the first half of 2005. Single stock options are less popular than futures. Index futures are increasingly popular, and accounted for close to 40% of traded value in October 2005. NSE launched interest rate futures in June 2003 but, in contrast to equity derivatives, there has been little trading in them. One problem with these instruments was faulty contract specifications, resulting in the underlying interest rate deviating erratically from the reference rate used by market participants. Institutional investors have preferred to trade in the OTC markets, where instruments such as interest rate swaps and forward rate agreements are thriving. As interest rates in India have fallen, companies have swapped their fixed rate borrowings into floating rates to reduce funding costs. 10 Activity in OTC markets dwarfs that of the entire exchange-traded markets, with daily value of trading estimated to be Rs. 30 billion in 2004 (FitchRatings, 2004). Foreign exchange derivatives are less active than interest rate derivatives in India, even though they have been around for longer. OTC instruments in currency forwards and swaps are the most popular. Importers, exporters and banks use the rupee forward market to hedge their foreign currency exposure. Turnover and liquidity in this market has been increasing, although trading is mainly in shorter maturity contracts of one year or less (Gambhir and Goel, 2003). In a currency swap, banks and corporations may swap its rupee denominated debt into another currency (typically the US dollar or Japanese yen), or vice versa. Trading in OTC currency options is still muted. There are no exchange- traded currency derivatives in India. Exchange-traded commodity derivatives have been trading only since 2000, and the growth in this market has been uneven. The number of commodities eligible for futures trading has increased from 8 in 2000 to 80 in 2004, while the value of trading has increased almost four times in the same period (Nair, 2004). However, many contracts barely trade and, of those that are active, trading is fragmented over multiple market venues, including central and regional exchanges, brokerages, and unregulated forwards markets. Total volume of commodity derivatives is still small, less than half the size of equity derivatives (Gorham et al, 2005).

11

DERIVATIVES USERS IN INDIA The use of derivatives varies by type of institution. Financial institutions, such as banks, have assets and liabilities of different maturities and in different currencies, and are exposed to different risks of default from their borrowers. Thus, they are likely to use derivatives on interest rates and currencies, and derivatives to manage credit risk. Non- financial institutions are regulated differently from financial institutions, and this affects their incentives to use derivatives. Indian insurance regulators, for example, are yet to issue guidelines relating to the use of derivatives by insurance companies. In India, financial institutions have not been heavy users of exchange-traded derivatives so far, with their contribution to total value of NSE trades being less than 8% in October 2005. However, market insiders feel that this may be changing, as indicated by the growing share of index derivatives (which are used more by institutions than by retail investors). In contrast to the exchange-traded markets, domestic financial institutions and mutual funds have shown great interest in OTC fixed income instruments. Transactions between banks dominate the market for interest rate derivatives, while state-owned banks remain a small presence (Chitale, 2003). Corporations are active in the currency forwards and swaps markets, buying these instruments from banks. Why do institutions not participate to a greater extent in derivatives markets? Some institutions such as banks and mutual funds are only allowed to use derivatives to hedge their existing positions in the spot market, or to rebalance their existing portfolios. Since banks have little exposure to equity markets due to banking regulations, they have little incentive to trade equity derivatives. Foreign investors must register as foreign institutional investors (FII) to trade exchange-traded derivatives, and be subject to position limits as specified by SEBI. Alternatively, they can incorporate locally as a instruments is limited to 5% of total outstanding advances as of the previous year-end. Some banks may have further equity exposure on account of equities collaterals held against loans in default broker-dealer. FIIs have a small but increasing presence in the equity derivatives markets. They have no incentive to trade interest rate derivatives since they have little investments in the domestic bond markets (Chitale, 2003). It is possible that unregistered foreign investors and hedge funds trade indirectly, using a local proprietary trader as a front (Lee, 2004). Retail investors (including small brokerages trading for themselves) are the major participants in equity derivatives, accounting for about 60% of turnover in October 2005, according to NSE. The success of single stock futures in India is unique, as this instrument has generally failed in most other countries. One reason for this success may be retail investors prior familiarity with badla trades which shared some features of derivatives trading. Another reason may be the small size of the futures contracts compared to similar contracts in other countries. Retail investors also dominate the markets for commodity derivatives, due in part to their long-standing expertise in trading in the havala or forwards markets.
12

SUMMARY AND CONCLUSIONS In terms of the growth of derivatives markets, and the variety of derivatives users, the Indian market has equaled or exceeded many other regional markets. 13 While the growth is being spearheaded mainly by retail investors, private sector institutions and large corporations, smaller companies and state-owned institutions are gradually getting into the act. Foreign brokers such as JP Morgan Chase are boosting their presence in India in reaction to the growth in derivatives. The variety of derivatives instruments available for trading is also expanding. There remain major areas of concern for Indian derivatives users. Large gaps exist in the range of derivatives products that are traded actively. In equity derivatives, NSE figures show that almost 90% of activity is due to stock futures or index futures, whereas trading in options is limited to a few stocks, partly because they are settled in cash and not the underlying stocks. Exchange-traded derivatives based on interest rates and currencies are virtually absent. Liquidity and transparency are important properties of any developed market. Liquid markets require market makers who are willing to buy and sell, and be patient while doing so. In India, market making is primarily the province of Indian private and foreign banks, with public sector banks lagging in this area (Fitch Ratings, 2004). A lack of market liquidity may be responsible for inadequate trading in some markets. Transparency is achieved partly through financial disclosure. In practice, some foreign investors also invest in Indian markets by issuing Participatory Notes to an off- shore investor Among exchange-traded derivative markets in Asia, India was ranked second behind S. Korea for the first quarter of 2005. How about China, with who India is frequently compared in other respects? China is preparing to develop its derivatives markets rapidly. It has recently entered into joint ventures with the leading U.S. futures exchanges. It has taken steps to loosen currency controls, and the Central Bank has allowed domestic and foreign banks to trade yuan forward and swaps contracts on behalf of clients. However, unlike India, China has not fully implemented necessary reforms of its stock markets, which is likely to hamper growth of its derivatives markets. currently provide misleading information on institutions use of derivatives. Further, there is no consistent method of accounting for gains and losses from derivatives trading. Thus, a proper framework to account for derivatives needs to be developed.

Further regulatory reform will help the markets grow faster. For example, Indian commodity derivatives have great growth potential but government policies have resulted in the underlying spot/physical market being fragmented (e.g. due to lack of free movement of commodities and differential taxation within India). Similarly, credit derivatives, the fastest

13

growing segment of the market globally, are absent in India and require regulatory action if they are to develop. As Indian derivatives markets grow more sophisticated, greater investor awareness will become essential. NSE has programs to inform and educate brokers, dealers, traders, and market personnel. In addition, institutions will need to devote more resources to develop the business processes and technology necessary for derivatives trading.

RBI (Reserve Bank of India) Regulations:

The exposures for which the rupee forward contracts are allowed under the existing RBI notification for various participants are as follows: I. Residents: Genuine underlying exposures out of trade/business Exposures due to foreign currency loans and bonds approved by RBI Receipts from GDR issued Balances in EEFC accounts

II. Foreign Institutional Investors: They should have exposures in India Hedge value not to exceed 15% of equity as of 31 March 1999 plus increase in market value/ inflows

III. Nonresident Indians/ Overseas Corporates: Dividends from holdings in a Indian company Deposits in FCNR and NRE accounts Investments under portfolio scheme in accordance with FERA or FEMA

14

FOREIGN EXCHANGE MANAGEMENT ACT, 1999

An Act to consolidate and amend the law relating to foreign exchange with the objective of facilitating external trade and payments and for promoting the orderly development and maintenance of foreign exchange market in India. BE it enacted by Parliament in the Fiftieth Year of the Republic of India as follows:

CHAPTER- I PRELIMINARY
SHORT TITLE, EXTENT, APPLICATION AND COMMENCEMENT. (1) This Act may be called the Foreign Exchange Management Act, 1999. (2) It extends to the whole of India. (3) It shall also apply to all branches, offices and agencies outside India owned or controlled by a person resident in India and also to any contravention thereunder committed outside India by any person to whom this Act applies. (4) It shall come into force on such date as the Central Government may, by notification in the Official Gazette, appoint: Provided that different dates may be appointed for different provisions of this Act and any reference in any such provision to the commencement of this Act shall be construed as a reference to the coming into force of that provision. Definitions 2. In this Act, unless the context otherwise requires, (a) "Adjudicating Authority" means an officer authorized under sub-section (1) of section 16; (b) "Appellate Tribunal" means the Appellate Tribunal for Foreign Exchange established under section 18;

15

(c) "authorized person" means an authorized dealer, money changer, off-shore banking unit or any other person for the time being authorized under sub-section (1) of section 10 to deal in foreign exchange or foreign securities; (d) "Bench" means a Bench of the Appellate Tribunal; (e) "capital account transaction" means a transaction which alters the assets or liabilities, including contingent liabilities, outside India of persons resident in India or assets or liabilities in India of persons resident outside India, and includes transactions referred to in sub-section (3) of section 6; (f) "Chairperson" means the Chairperson of the Appellate Tribunal; (g) "chartered accountant" shall have the meaning assigned to it in clause (b) of sub-section (1) of section 2 of the Chartered Accountants Act, 1949 (38 of 1949); (h) "currency" includes all currency notes, postal notes, postal orders, money orders, cheques, drafts, travellers cheques, letters of credit, bills of exchange and promissory notes, credit cards or such other similar instruments, as may be notified by the Reserve Bank; (i) "currency notes" means and includes cash in the form of coins and bank notes;

(j) "current account transaction" means a transaction other than a capital account transaction and without prejudice to the generality of the foregoing such transaction includes:(i) payments due in connection with foreign trade, other current business, services, and short-term banking and credit facilities in the ordinary course of business, payments due as interest on loans and as net income from investments,

(ii)

(iii) (iv)

remittances for living expenses of parents, spouse and children residing abroad, and expenses in connection with foreign travel, education and medical care of parents, spouse and children;

(k) "Director of Enforcement" means the Director of Enforcement appointed under subsection (1) of section 36; (l) "export", with its grammatical variations and cognate expressions, means (i) the taking out of India to a place outside India any goods,
16

(ii)

provision of services from India to any person outside India;

(m) "foreign currency" means any currency other than Indian currency; (n) "foreign exchange" means foreign currency and includes, (i) deposits, credits and balances payable in any foreign currency,

(ii) drafts, travellers cheques, letters of credit or bills of exchange, expressed or drawn in Indian currency but payable in any foreign currency, (ii) drafts, travellers cheques, letters of credit or bills of exchange drawn by banks, institutions or persons outside India, but payable in Indian currency;

(o) "foreign security" means any security, in the form of shares, stocks, bonds, debentures or any other instrument denominated or expressed in foreign currency and includes securities expressed in foreign currency, but where redemption or any form of return such as interest or dividends is payable in Indian currency; (p) "import", with its grammatical variations and cognate expressions, means bringing into India any goods or services; (q) "Indian currency" means currency which is expressed or drawn in Indian rupees but does not include special bank notes and special one rupee notes issued under section 28A of the Reserve Bank of India Act, 1934 (2 of 1934); (r) "legal practitioner" shall have the meaning assigned to it in clause (i) of sub-section (1) of section 2 of the Advocates Act, 1961 (25 of 1961); (s) "Member" means a Member of the Appellate Tribunal and includes the Chairperson thereof; (t) "notify" means to notify in the Official Gazette and the expression "notification" shall be construed accordingly; (u) "person" includes (i) an individual, (ii) a Hindu undivided family, (iii) a company,
17

(iv) a firm, (v) an association of persons or a body of individuals, whether incorporated or not, (vi) every artificial juridical person, not falling within any of the preceding sub-clauses, and (vii) any agency, office or branch owned or controlled by such person; (v) "person resident in India" means (i) a person residing in India for more than one hundred and eighty-two days during the course of the preceding financial year but does not include (A) a person who has gone out of India or who stays outside India, in either case (a) for or on taking up employment outside India, or (b) for carrying on outside India a business or vocation outside India, or (c) for any other purpose, in such circumstances as would indicate his intention to stay outside India for an uncertain period; (B) a person who has come to or stays in India, in either case, otherwise than (a) for or on taking up employment in India, or (b) for carrying on in India a business or vocation in India, or (c) for any other purpose, in such circumstances as would indicate his intention to stay in India for an uncertain period; (ii) any person or body corporate registered or incorporated in India, (iii) an office, branch or agency in India owned or controlled by a person resident outside India, (iv) an office, branch or agency outside India owned or controlled by a person resident in India; (w) "person resident outside India" means a person who is not resident in India; (x) "prescribed" means prescribed by rules made under this Act; (y) "repatriate to India" means bringing into India the realized foreign exchange and
18

(i) the selling of such foreign exchange to an authorized person in India in exchange for rupees, or (ii) the holding of realized amount in an account with an authorized person in India to the extent notified by the Reserve Bank, and includes use of the realized amount for discharge of a debt or liability denominated in foreign exchange and the expression "repatriation" shall be construed accordingly;

CHAPTER II
REGULATION AND MANAGEMENT OF FOREIGN EXCHANGE DEALING IN FOREIGN EXCHANGE, ETC. 3. Save as otherwise provided in this Act, rules or regulations made thereunder, or with the general or special permission of the Reserve Bank, no person shall (a) deal in or transfer any foreign exchange or foreign security to any person not being an authorized person; (b) make any payment to or for the credit of any person resident outside India in any manner; (c) receive otherwise through an authorized person, any payment by order or on behalf of any person resident outside India in any manner; Explanation.For the purpose of this clause, where any person in, or resident in, India receives any payment by order or on behalf of any person resident outside India through any other person (including an authorized person) without a corresponding inward remittance from any place outside India, then, such person shall be deemed to have received such payment otherwise than through an authorized person; (d) enter into any financial transaction in India as consideration for or in association with acquisition or creation or transfer of a right to acquire, any asset outside India by any person. Explanation.For the purpose of this clause, "financial transaction" means making any payment to, or for the credit of any person, or receiving any payment for, by order or on behalf of any person, or drawing, issuing or negotiating any bill of exchange or promissory note, or transferring any security or acknowledging any debt. Holding of foreign exchange, etc.

19

4. Save as otherwise provided in this Act, no person resident in India shall acquire, hold, own, possess or transfer any foreign exchange, foreign security or any immovable property situated outside India. Current account transactions. 5. Any person may sell or draw foreign exchange to or from an authorized person if such sale or drawal is a current account transaction: Provided that the Central Government may, in public interest and in consultation with the Reserve Bank, impose such reasonable restrictions for current account transactions as may be prescribed. Capital account transactions. 6. (1) Subject to the provisions of sub-section (2), any person may sell or draw foreign exchange to or from an authorized person for a capital account transaction. (2) The Reserve Bank may, in consultation with the Central Government, specify (a) any class or classes of capital account transactions which are permissible; (b) the limit up to which foreign exchange shall be admissible for such transactions : Provided that the Reserve Bank shall not impose any restriction on the drawal of foreign exchange for payments due on account of amortization of loans or for depreciation of direct investments in the ordinary course of business. (3) Without prejudice to the generality of the provisions of sub-section (2), the Reserve Bank may, by regulations, prohibit, restrict or regulate the following (a) transfer or issue of any foreign security by a person resident in India; (b) transfer or issue of any security by a person resident outside India; (c) transfer or issue of any security or foreign security by any branch, office or agency in India of a person resident outside India; (d) any borrowing or lending in foreign exchange in whatever form or by whatever name called; (e) any borrowing or lending in rupees in whatever form or by whatever name called between a person resident in India and a person resident outside India; (f) deposits between persons resident in India and persons resident outside India;
20

(g) export, import or holding of currency or currency notes; (h) transfer of immovable property outside India, other than a lease not exceeding five years, by a person resident in India; (i) acquisition or transfer of immovable property in India, other than a lease not exceeding five years, by a person resident outside India; (j) giving of a guarantee or surety in respect of any debt, obligation or other liability incurred (i) by a person resident in India and owed to a person resident outside India; or (ii) by a person resident outside India. (4) A person resident in India may hold, own, transfer or invest in foreign currency, foreign security or any immovable property situated outside India if such currency, security or property was acquired, held or owned by such person when he was resident outside India or inherited from a person who was resident outside India. (5) A person resident outside India may hold, own, transfer or invest in Indian currency, security or any immovable property situated in India if such currency, security or property was acquired, held or owned by such person when he was resident in India or inherited from a person who was resident in India. (6) Without prejudice to the provisions of this section, the Reserve Bank may, by regulation, prohibit, restrict, or regulate establishment in India of a branch, office or other place of business by a person resident outside India, for carrying on any activity relating to such branch, office or other place of business. Export of goods and services. 7. (1) Every exporter of goods shall (a) furnish to the Reserve Bank or to such other authority a declaration in such form and in such manner as may be specified, containing true and correct material particulars, including the amount representing the full export value or, if the full export value of the goods is not ascertainable at the time of export, the value which the exporter, having regard to the prevailing market conditions, expects to receive on the sale of the goods in a market outside India; (b) furnish to the Reserve Bank such other information as may be required by the Reserve Bank for the purpose of ensuring the realisation of the export proceeds by such exporter.
21

(2) The Reserve Bank may, for the purpose of ensuring that the full export value of the goods or such reduced value of the goods as the Reserve Bank determines, having regard to the prevailing market conditions, is received without any delay, direct any exporter to comply with such requirements as it deems fit. (3) Every exporter of services shall furnish to the Reserve Bank or to such other authorities a declaration in such form and in such manner as may be specified, containing the true and correct material particulars in relation to payment for such services. Realization and repatriation of foreign exchange. 8. Save as otherwise provided in this Act, where any amount of foreign exchange is due or has accrued to any person resident in India, such person shall take all reasonable steps to realize and repatriate to India such foreign exchange within such period and in such manner as may be specified by the Reserve Bank. Exemption from realization and repatriation in certain cases. 9. The provisions of sections 4 and 8 shall not apply to the following, namely: (a) possession of foreign currency or foreign coins by any person up to such limit as the Reserve Bank may specify; (b) foreign currency account held or operated by such person or class of persons and the limit up to which the Reserve Bank may specify; (c) foreign exchange acquired or received before the 8th day of July, 1947 or any income arising or accruing thereon which is held outside India by any person in pursuance of a general or special permission granted by the Reserve Bank; (d) foreign exchange held by a person resident in India up to such limit as the Reserve Bank may specify, if such foreign exchange was acquired by way of gift or inheritance from a person referred to in clause (c), including any income arising therefrom; (e) foreign exchange acquired from employment, business, trade, vocation, services, honorarium, gifts, inheritance or any other legitimate means up to such limit as the Reserve Bank may specify; and (f) such other receipts in foreign exchange as the Reserve Bank may specify.

22

CHAPTER III
AUTHORIZED PERSON 10. (1) The Reserve Bank may, on an application made to it in this behalf, authorize any person to be known as authorized person to deal in foreign exchange or in foreign securities, as an authorized dealer, money changer or off-shore banking unit or in any other manner as it deems fit. (2) An authorization under this section shall be in writing and shall be subject to the conditions laid down therein. (3) An authorization granted under sub-section (1) may be revoked by the Reserve Bank at any time if the Reserve Bank is satisfied that (a) it is in public interest so to do; or (b) the authorized person has failed to comply with the condition subject to which the authorization was granted or has contravened any of the provisions of the Act or any rule, regulation, notification, direction or order made thereunder: Provided that no such authorization shall be revoked on any ground referred to in clause (b) unless the authorized person has been given a reasonable opportunity of making a representation in the matter. (4) An authorized person shall, in all his dealings in foreign exchange or foreign security, comply with such general or special directions or orders as the Reserve Bank may, from time to time, think fit to give, and, except with the previous permission of the Reserve Bank, an authorized person shall not engage in any transaction involving any foreign exchange or foreign security which is not in conformity with the terms of his authorization under this section. (5) An authorized person shall, before undertaking any transaction in foreign exchange on behalf of any person, require that person to make such declaration and to give such information as will reasonably satisfy him that the transaction will not involve, and is not designed for the purpose of any contravention or evasion of the provisions of this Act or of any rule, regulation, notification, direction or order made thereunder, and where the said person refuses to comply with any such requirement or makes only unsatisfactory compliance therewith, the authorized person shall refuse in writing to undertake the transaction and shall, if he has reason to believe that any such contravention or evasion as aforesaid is contemplated by the person, report the matter to the Reserve Bank. (6) Any person, other than an authorized person, who has acquired or purchased foreign exchange for any purpose mentioned in the declaration made by him to authorized person
23

under sub-section (5) does not use it for such purpose or does not surrender it to authorized person within the specified period or uses the foreign exchange so acquired or purchased for any other purpose for which purchase or acquisition of foreign exchange is not permissible under the provisions of the Act or the rules or regulations or direction or order made thereunder shall be deemed to have committed contravention of the provisions of the Act for the purpose of this section. Reserve Banks powers to issue directions to authorized person. 11. (1) The Reserve Bank may, for the purpose of securing compliance with the provisions of this Act and of any rules, regulations, notifications or directions made thereunder, give to the authorized persons any direction in regard to making of payment or the doing or desist from doing any act relating to foreign exchange or foreign security. (2) The Reserve Bank may, for the purpose of ensuring the compliance with the provisions of this Act or of any rule, regulation, notification, direction or order made thereunder, direct any authorized person to furnish such information, in such manner, as it deems fit. (3) Where any authorized person contravenes any direction given by the Reserve Bank under this Act or fails to file any return as directed by the Reserve Bank, the Reserve Bank may, after giving reasonable opportunity of being heard, impose on the authorized person a penalty which may extend to ten thousand rupees and in the case of continuing contravention with an additional penalty which may extend to two thousand rupees for every day during which such contravention continues. Power of Reserve Bank to inspect authorized person. 12. (1) The Reserve Bank may, at any time, cause an inspection to be made, by any officer of the Reserve Bank specially authorized in writing by the Reserve Bank in this behalf, of the business of any authorized person as may appear to it to be necessary or expedient for the purpose of (a) verifying the correctness of any statement, information or particulars furnished to the Reserve Bank; (b) obtaining any information or particulars which such authorized person has failed to furnish on being called upon to do so; (c) securing compliance with the provisions of this Act or of any rules, regulations, directions or orders made thereunder. (2) It shall be the duty of every authorized person, and where such person is a company or a firm, every director, partner or other officer of such company or firm, as the case may be, to produce to any officer making an inspection under sub-section (1), such books, accounts
24

and other documents in his custody or power and to furnish any statement or information relating to the affairs of such person, company or firm as the said officer may require within such time and in such manner as the said officer may direct.

CHAPTER V
ADJUDICATION AND APPEAL APPOINTMENT OF ADJUDICATING AUTHORITY. 16. (1) For the purpose of adjudication under section 13, the Central Governmeant may, by an order published in the Official Gazette, appoint as many officers of the Central Government as it may think fit, as the Adjudicating Authorities for holding an inquiry in the manner prescribed after giving the person alleged to have committed contravention under section 13, against whom a complaint has been made under sub-section (2) (hereinafter in this section referred to as the said person) a reasonable opportunity of being heard for the purpose of imposing any penalty: Provided that where the Adjudicating Authority is of opinion that the said person is likely to abscond or is likely to evade in any manner, the payment of penalty, if levied, it may direct the said person to furnish a bond or guarantee for such amount and subject to such conditions as it may deem fit. (2) The Central Government shall, while appointing the Adjudicating Authorities under sub-section (1), also specify in the order published in the Official Gazette, their respective jurisdictions. (3) No Adjudicating Authority shall hold an enquiry under sub-section (1) except upon a complaint in writing made by any officer authorized by a general or special order by the Central Government. (4) The said person may appear either in person or take the assistance of a legal practitioner or a chartered accountant of his choice for presenting his case before the Adjudicating Authority. (5) Every Adjudicating Authority shall have the same powers of a civil court which are conferred on the Appellate Tribunal under sub-section (2) of section 28 and (a) all proceedings before it shall be deemed to be judicial proceedings within the meaning of sections 193 and 228 of the Indian Penal Code (45 of 1860); (b) shall be deemed to be a civil court for the purposes of sections 345 and 346 of the Code of Criminal Procedure, 1973 (2 of 1974).

25

(6) Every Adjudicating Authority shall deal with the complaint under sub-section (2) as expeditiously as possible and endeavor shall be made to dispose of the complaint finally within one year from the date of receipt of the complaint : Provided that where the complaint cannot be disposed of within the said period, the Adjudicating Authority shall record periodically the reasons in writing for not disposing off the complaint within the said period. Appeal to Special Director (Appeals). 17. (1) The Central Government shall, by notification, appoint one or more Special Directors (Appeals) to hear appeals against the orders of the Adjudicating Authorities under this section and shall also specify in the said notification the matter and places in relation to which the Special Director (Appeals) may exercise jurisdiction. (2) Any person aggrieved by an order made by the Adjudicating Authority, being an Assistant Director of Enforcement or a Deputy Director of Enforcement, may prefer an appeal to the Special Director (Appeals). (3) Every appeal under sub-section (1) shall be filed within forty-five days from the date on which the copy of the order made by the Adjudicating Authority is received by the aggrieved person and it shall be in such form, verified in such manner and be accompanied by such fee as may be prescribed : Provided that the Special Director (Appeals) may entertain an appeal after the expiry of the said period of forty-five days, if he is satisfied that there was sufficient cause for not filing it within that period. (4) On receipt of an appeal under sub-section (1), the Special Director (Appeals) may after giving the parties to the appeal an opportunity of being heard, pass such order thereon as he thinks fit confirming, modifying or setting aside the order appealed against. (5) The Special Director (Appeals) shall send a copy of every order made by him to the parties to appeal and to the concerned Adjudicating Authority. (6) The Special Director (Appeals) shall have the same powers of a civil court which are conferred on the Appellate Tribunal under sub-section (2) of section 28 and (a) all proceedings before him shall be deemed to be judicial proceedings within the meaning of sections 193 and 228 of the Indian Penal Code (45 of 1860); (b) shall be deemed to be a civil court for the purposes of sections 345 and 346 of the Code of Criminal Procedure, 1973 (2 of 1974).
26

Establishment of Appellate Tribunal. 18. The Central Government shall, by notification, establish an Appellate Tribunal to be known as the Appellate Tribunal for Foreign Exchange to hear appeals against the orders of the Adjudicating Authorities and the Special Director (Appeals) under this Act. Appeal to Appellate Tribunal. 19. (1) Save as provided in sub-section (2), the Central Government or any person aggrieved by an order made by an Adjudicating Authority, other than those referred to subsection (1) of section 17, or the Special Director (Appeals), may prefer an appeal to the Appellate Tribunal: Provided that any person appealing against the order of the Adjudicating Authority or the Special Director (Appeals) levying any penalty, shall while filing the appeal, deposit the amount of such penalty with such authority as may be notified by the Central Government : Provided further that where in any particular case, the Appellate Tribunal is of the opinion that the deposit of such penalty would cause undue hardship to such person, the Appellate Tribunal may dispense with such deposit subject to such conditions as it may deem fit to impose so as to safeguard the realization of penalty. (2) Every appeal under sub-section (1) shall be filed within a period of forty-five days from the date on which a copy of the order made by the Adjudicating Authority or the Special Director (Appeals) is received by the aggrieved person or by the Central Government and it shall be in such form, verified in such manner and be accompanied by such fee as may be prescribed : Provided that the Appellate Tribunal may entertain an appeal after the expiry of the said period of forty-five days if it is satisfied that there was sufficient cause for not filing it within that period. (3) On receipt of an appeal under sub-section (1), the Appellate Tribunal may, after giving the parties to the appeal an opportunity of being heard, pass such orders thereon as it thinks fit, confirming, modifying or setting aside the order appealed against. (4) The Appellate Tribunal shall send a copy of every order made by it to the parties to the appeal and to the concerned Adjudicating Authority or the Special Director (Appeals), as the case may be. (5) The appeal filed before the Appellate Tribunal under sub-section (1) shall be dealt with by it as expeditiously as possible and endeavor shall be made by it to dispose of the appeal finally within one hundred and eighty days from the date of receipt of the appeal:

27

Provided that where any appeal could not be disposed of within the said period of one hundred and eighty days, the Appellate Tribunal shall record its reasons in writing for not disposing of the appeal within the said period. (6) The Appellate Tribunal may, for the purpose of examining the legality, propriety or correctness of any order made by the Adjudicating Authority under section 16 in relation to any proceeding, on its own motion or otherwise, call for the records of such proceedings and make such order in the case as it thinks fit.

Composition of Appellate Tribunal. 20. (1) The Appellate Tribunal shall consist of a Chairperson and such number of Members as the Central Government may deem fit. (2) Subject to the provisions of this Act, (a) the jurisdiction of the Appellate Tribunal may be exercised by Benches thereof; (b) a Bench may be constituted by the Chairperson with one or more Members as the Chairperson may deem fit; (c) the Benches of the Appellate Tribunal shall ordinarily sit at New Delhi and at such other places as the Central Government may, in consultation with the Chairperson, notify; (d) the Central Government shall notify the areas in relation to which each Bench of the Appellate Tribunal may exercise jurisdiction. (3) Notwithstanding anything contained in sub-section (2), the Chairperson may transfer a Member from one Bench to another Bench. (4) If at any stage of the hearing of any case or matter it appears to the Chairperson or a Member that the case or matter is of such a nature that it ought to be heard by a Bench consisting of two Members, the case or matter may be transferred by the Chairperson or, as the case may be, referred to him for transfer, to such Bench as the Chairperson may deem fit. Qualifications for appointment of Chairperson, Member and Special Director (Appeals). 21. (1) A person shall not be qualified for appointment as the Chairperson or a Member unless he
28

(a) in the case of Chairperson, is or has been, or is qualified to be, a Judge of a High Court; and (b) in the case of a Member, is or has been, or is qualified to be, a District Judge. (2) A person shall not be qualified for appointment as a Special Director (Appeals) unless he (a) has been a member of the Indian Legal Service and has held a post in Grade I of that Service; or (b) has been a member of the Indian Revenue Service and has held a post equivalent to a Joint Secretary to the Government of India. Term of office. 22. The Chairperson and every other Member shall hold office as such for a term of five years from the date on which he enters upon his office : Provided that no Chairperson or other Member shall hold office as such after he has attained, (a) in the case of the Chairperson, the age of sixty-five years; (b) in the case of any other Member, the age of sixty-two years. Terms and conditions of service. 23. The salary and allowances payable to and the other terms and conditions of service of the Chairperson, other Members and the Special Director (Appeals) shall be such as may be prescribed: Provided that neither the salary and allowances nor the other terms and conditions of service of the Chairperson or a Member shall be varied to his disadvantage after appointment. Vacancies. 24. If, for reason other than temporary absence, any vacancy occurs in the office of the Chairperson or a Member, the Central Government shall appoint another person in accordance with the provisions of this Act to fill the vacancy and the proceedings may be continued before the Appellate Tribunal from the stage at which the vacancy is filled. Resignation and removal.

29

25. (1) The Chairperson or a Member may, by notice in writing under his hand addressed to the Central Government, resign his office: Provided that the Chairperson or a Member shall, unless he is permitted by the Central Government to relinquish his office sooner, continue to hold office until the expiry of three months from the date of receipt of such notice or until a person duly appointed as his successor enters upon his office or until the expiry of term of office, whichever is the earliest. (2) The Chairperson or a Member shall not be removed from his office except by an order by the Central Government on the ground of proved misbehavior or incapacity after an inquiry made by such person as the President may appoint for this purpose in which the Chairperson or a Member concerned has been informed of the charges against him and given a reasonable opportunity of being heard in respect of such charges. Member to act as Chairperson in certain circumstances. 26. (1) In the event of the occurrence of any vacancy in the office of the Chairperson by reason of his death, resignation or otherwise, the senior-most Member shall act as the Chairperson until the date on which a new Chairperson, appointed in accordance with the provisions of this Act to fill such vacancy, enters upon his office. (2) When the Chairperson is unable to discharge his functions owing to absence, illness or any other cause, the senior most Member shall discharge the functions of the Chairperson until the date on which the Chairperson resumes his duties. Staff of Appellate Tribunal and Special Director (Appeals). 27. (1) The Central Government shall provide the Appellate Tribunal and the Special Director (Appeals) with such officers and employees as it may deem fit. (2) The officers and employees of the Appellate Tribunal and office of the Special Director (Appeals) shall discharge their functions under the general superintendence of the Chairperson and the Special Director (Appeals), as the case may be. (3) The salaries and allowances and other conditions of service of the officers and employees of the Appellate Tribunal and office of the Special Director (Appeals) shall be such as may be prescribed. Procedure and powers of Appellate Tribunal and Special Director (Appeals) 28. (1) The Appellate Tribunal and the Special Director (Appeals) shall not be bound by the procedure laid down by the Code of Civil Procedure, 1908 (5 of 1908) but shall be guided by the principles of natural justice and, subject to the other provisions of this Act, the
30

Appellate Tribunal and the Special Director (Appeals) shall have powers to regulate its own procedure. (2) The Appellate Tribunal and the Special Director (Appeals) shall have, for the purposes of discharging its functions under this Act, the same powers as are vested in a civil court under the Code of Civil Procedure, 1908 (5 of 1908); while trying a suit, in respect of the following matters, namely: (a) summoning and enforcing the attendance of any person and examining him on oath; (b) requiring the discovery and production of documents; (c) receiving evidence on affidavits; (d) subject to the provisions of sections 123 and 124 of the Indian Evidence Act, 1872 (1 of 1872) requisitioning any public record or document or copy of such record or document from any office; (e) issuing commissions for the examination of witnesses or documents; (f) reviewing its decisions; (g) dismissing a representation of default or deciding it ex parte; (h) setting aside any order of dismissal of any representation for default or any order passed by it ex parte; and (i) any other matter which may be prescribed by the Central Government. (3) An order made by the Appellate Tribunal or the Special Director (Appeals) under this Act shall be executable by the Appellate Tribunal or the Special Director (Appeals) as a decree of civil court and, for this purpose, the Appellate Tribunal and the Special Director (Appeals) shall have all the powers of a civil court. (4) Notwithstanding anything contained in sub-section (3), the Appellate Tribunal or the Special Director (Appeals) may transmit any order made by it to a civil court having local jurisdiction and such civil court shall execute the order as if it were a decree made by that court. (5) All proceedings before the Appellate Tribunal and the Special Director (Appeals) shall be deemed to be judicial proceedings within the meaning of sections 193 and 228 of the Indian Penal Code (45 of 1860) and the Appellate Tribunal shall be deemed to be a civil court for the purposes of sections 345 and 346 of the Code of Criminal Procedure, 1973 (2 of 1974)
31

Distribution of business amongst Benches. 29. Where Benches are constituted, the Chairperson may, from time to time, by notification, make provisions as to the distribution of the business of the Appellate Tribunal amongst the Benches and also provide for the matters which may be dealt with by each Bench. Power of Chairperson to transfer cases. 30. On the application of any of the parties and after notice to the parties, and after hearing such of them as he may desire to be heard, or on his own motion without such notice, the Chairperson may transfer any case pending before one Bench, for disposal, to any other Bench. Decision to be by majority. 31. If the Members of a Bench consisting of two Members differ in opinion on any point, they shall state the point or points on which they differ, and make a reference to the Chairperson who shall either hear the point or points himself or refer the case for hearing on such point or points by one or more of the other Members of the Appellate Tribunal and such point or points shall be decided according to the opinion of the majority of the Members of the Appellate Tribunal who have heard the case, including those who first heard it. Right of appellant to take assistance of legal practitioner or chartered accountant and of Government, to appoint presenting officers. 32. (1) A person preferring an appeal to the Appellate Tribunal or the Special Director (Appeals) under this Act may either appear in person or take the assistance of a legal practitioner or a chartered accountant of his choice to present his case before the Appellate Tribunal or the Special Director (Appeals), as the case may be. (2) The Central Government may authorize one or more legal practitioners or chartered accountants or any of its officers to act as presenting officers and every person so authorized may present the case with respect to any appeal before the Appellate Tribunal or the Special Director (Appeals), as the case may be. Members, etc. to be public servants.

32

33. The Chairperson, Members and other officers and employees of the Appellate Tribunal, the Special Director (Appeals) and the Adjudicating Authority shall be deemed to be public servants within the meaning of section 21 of the Indian Penal Code (45 of 1860).

Civil court not to have jurisdiction. 34. No civil court shall have jurisdiction to entertain any suit or proceeding in respect of any matter which an Adjudicating Authority or the Appellate Tribunal or the Special Director (Appeals) is empowered by or under this Act to determine and no injunction shall be granted by any court or other authority in respect of any action taken or to be taken in pursuance of any power conferred by or under this Act. Appeal to High Court. 35. Any person aggrieved by any decision or order of the Appellate Tribunal may file an appeal to the High Court within sixty days from the date of communication of the decision or order of the Appellate Tribunal on any question of law arising out of such order: Provided that the High Court may, if it is satisfied that the appellant was prevented by sufficient cause from filing the appeal within the said period, allow it to be filed within a further period not exceeding sixty days. Explanation.In this section "High Court" means (a) the High Court within the jurisdiction of which the aggrieved party ordinarily resides or carries on business or personally works for gain; and (b) where the Central Government is the aggrieved party, the High Court within the jurisdiction of which the respondent, or in a case where there are more than one respondent, any of the respondents, ordinarily resides or carries on business or personally works for gain.

33

CHAPTER VI
DIRECTORATE OF ENFORCEMENT DIRECTORATE OF ENFORCEMENT. 36. (1) The Central Government shall establish a Directorate of Enforcement with a Director and such other officers or class of officers as it thinks fit, who shall be called officers of Enforcement, for the purposes of this Act. (2) Without prejudice to provisions of sub-section (1), the Central Government may authorize the Director of Enforcement or an Additional Director of Enforcement or a Special Director of Enforcement or a Deputy Director of Enforcement to appoint officers of Enforcement below the rank of an Assistant Director of Enforcement. (3) Subject to such conditions and limitations as the Central Government may impose, an officer of Enforcement may exercise the powers and discharge the duties conferred or imposed on him under this Act. Power of search, seizure, etc. 37. (1) The Director of Enforcement and other officers of Enforcement, not below the rank of an Assistant Director, shall take up for investigation the contravention referred to in section 13. (2) Without prejudice to the provisions of sub-section (1), the Central Government may also, by notification, authorize any officer or class of officers in the Central Government, State Government or the Reserve Bank, not below the rank of an Under Secretary to the Government of India to investigate any contravention referred to in section 13. (3) The officers referred to in sub-section (1) shall exercise the like powers which are conferred on income-tax authorities under the Income-tax Act, 1961 (43 of 1961) and shall exercise such powers, subject to such limitations laid down under that Act. Empowering other officers. 38. (1) The Central Government may, by order and subject to such conditions and limitations as it thinks fit to impose, authorize any officer of customs or any central excise officer or any police officer or any other officer of the Central Government or a State Government to exercise such of the powers and discharge such of the duties of the Director of Enforcement or any other officer of Enforcement under this Act as may be stated in the order.

34

(2) The officers referred to in sub-section (1) shall exercise the like powers which are conferred on the income-tax authorities under the Income-tax Act, 1961 (43 of 1961), subject to such conditions and limitations as the Central Government may impose.

CHAPTER VII
MISCELLANEOUS PRESUMPTION AS TO DOCUMENTS IN CERTAIN CASES. 39. Where any document (i) is produced or furnished by any person or has been seized from the custody or control of any person, in either case, under this Act or under any other law; or (ii) has been received from any place outside India (duly authenticated by such authority or person and in such manner as may be prescribed) in the course of investigation of any contravention under this Act alleged to have been committed by any person, and such document is tendered in any proceeding under this Act in evidence against him, or against him and any other person who is proceeded against jointly with him, the court or the Adjudicating Authority, as the case may be, shall (a) presume, unless the contrary is proved, that the signature and every other part of such document which purports to be in the handwriting of any particular person or which the court may reasonably assume to have been signed by, or to be in the handwriting of, any particular person, is in that persons handwriting, and in the case of a document executed or attested, that it was executed or attested by the person by whom it purports to have been so executed or attested; (b) admit the document in evidence notwithstanding that it is not duly stamped, if such document is otherwise admissible in evidence; (c) in a case falling under clause (i), also presume, unless the contrary is proved, the truth of the contents of such document. Suspension of operation of this Act. 40. (1) If the Central Government is satisfied that circumstances have arisen rendering it necessary that any permission granted or restriction imposed by this Act should cease to be granted or imposed, or if it considers necessary or expedient so to do in public interest, the
35

Central Government may, by notification, suspend or relax to such extent either indefinitely or for such period as may be notified, the operation of all or any of the provisions of this Act. (2) Where the operation of any provision of this Act has under sub-section (1) been suspended or relaxed indefinitely, such suspension or relaxation may, at any time while this Act remains in force, be removed by the Central Government by notification. (3) Every notification issued under this section shall be laid, as soon as may be after it is issued, before each House of Parliament, while it is in session, for a total period of thirty days which may be comprised in one session or in two or more successive sessions, and if, before the expiry of the session immediately following the session or the successive sessions aforesaid, both Houses agree in making any modification in the notification or both Houses agree that the notification should not be issued, the notification shall thereafter have effect only in such modified form or be of no effect, as the case may be; so, however, that any such modification or annulment shall be without prejudice to the validity of anything previously done under that notification. Power of Central Government to give directions. 41. For the purposes of this Act, the Central Government may, from time to time, give to the Reserve Bank such general or special directions as it thinks fit, and the Reserve Bank shall, in the discharge of its functions under this Act, comply with any such directions. Contravention by companies. 42. (1) Where a person committing a contravention of any of the provisions of this Act or of any rule, direction or order made thereunder is a company, every person who, at the time the contravention was committed, was in charge of, and was responsible to, the company for the conduct of the business of the company as well as the company, shall be deemed to be guilty of the contravention and shall be liable to be proceeded against and punished accordingly : Provided that nothing contained in this sub-section shall render any such person liable to punishment if he proves that the contravention took place without his knowledge or that he exercised due diligence to prevent such contravention. (2) Notwithstanding anything contained in sub-section (1), where a contravention of any of the provisions of this Act or of any rule, direction or order made thereunder has been committed by a company and it is proved that the contravention has taken place with the consent or connivance of, or is attributable to any neglect on the part of, any director, manager, secretary or other officer of the company, such director, manager, secretary or other officer shall also be deemed to be guilty of the contravention and shall be liable to be proceeded against and punished accordingly.
36

Explanation.For the purposes of this section (i) "company" means anybody corporate and includes a firm or other association of individuals; and (ii) "director", in relation to a firm, means a partner in the firm. Death or insolvency in certain cases. 43. Any right, obligation, liability, proceeding or appeal arising in relation to the provisions of section 13 shall not abate by reason of death or insolvency of the person liable under that section and upon such death or insolvency such rights and obligations shall devolve on the legal representative of such person or the official receiver or the official assignee, as the case may be : Provided that a legal representative of the deceased shall be liable only to the extent of the inheritance or estate of the deceased. Bar of legal proceedings. 44. No suit, prosecution or other legal proceeding shall lie against the Central Government or the Reserve Bank or any officer of that Government or of the Reserve Bank or any other person exercising any power or discharging any functions or performing any duties under this Act, for anything in good faith done or intended to be done under this Act or any rule, regulation, notification, direction or order made thereunder. Removal of difficulties. 45. (1) If any difficulty arises in giving effect to the provisions of this Act, the Central Government may, by order, do anything not inconsistent with the provisions of this Act for the purpose of removing the difficulty: Provided that no such order shall be made under this section after the expiry of two years from the commencement of this Act. (2) Every order made under this section shall be laid, as soon as may be after it is made, before each House of Parliament.

37

Power to make rules. 46. (1) The Central Government may, by notification, make rules to carry out the provisions of this Act. (2) Without prejudice to the generality of the foregoing power, such rules may provide for, (a) the imposition of reasonable restrictions on current account transactions under section 5; (b) the manner in which the contravention may be compounded under sub-section (1) of section 15; (c) the manner of holding an inquiry by the Adjudicating Authority under sub-section (1) of section 16; (d) the form of appeal and fee for filing such appeal under sections 17 and 19; (e) the salary and allowances payable to and the other terms and conditions of service of the Chairperson and other Members of the Appellate Tribunal and the Special Director (Appeals) under section 23; (f) the salaries and allowances and other conditions of service of the officers and employees of the Appellate Tribunal and the office of the Special Director (Appeals) under sub-section (3) of section 27; (g) the additional matters in respect of which the Appellate Tribunal and the Special Director (Appeals) may exercise the powers of civil court under clause (i) of sub-section (2) of section 28; (h) the authority or person and the manner in which any document may be authenticated under clause (ii) of section 39; and (i) any other matter which is required to be, or may be, prescribed.

38

Power to make regulations. 47. (1) The Reserve Bank may, by notification, make regulations to carry out the provisions of this Act and the rules made thereunder. (2) Without prejudice to the generality of the foregoing power, such regulations may provide for, (a) the permissible classes of capital account transactions, the limits of admissibility of foreign exchange for such transactions, and the prohibition, restriction or regulation of certain capital account transactions under section 6; (b) the manner and the form in which the declaration is to be furnished under clause (a) of sub-section (1) of section 7; (c) the period within which and the manner of repatriation of foreign exchange under section 8; (d) the limit up to which any person may possess foreign currency or foreign coins under clause (a) of section 9; (e) the class of persons and the limit up to which foreign currency account may be held or operated under clause (b) of section 9; (f) the limit up to which foreign exchange acquired may be exempted under clause (d) of section 9; (g) the limit up to which foreign exchange acquired may be retained under clause (e) of section 9; (h) any other matter which is required to be, or may be, specified.

39

Rules and regulations to be laid before Parliament. 48. Every rule and regulation made under this Act shall be laid, as soon as may be after it is made, before each House of Parliament, while it is in session for a total period of thirty days which may be comprised in one session or in two or more successive sessions, and if, before the expiry of the session immediately following the session or the successive sessions aforesaid, both Houses agree in making any modification in the rule or regulation, or both Houses agree that the rule or regulation should not be made, the rule or regulation shall thereafter have effect only in such modified form or be of no effect, as the case may be; so, however, that any such modification or annulment shall be without prejudice to the validity of anything previously done under that rule or regulation. Repeal and saving. 49. (1) The Foreign Exchange Regulation Act, 1973 (46 of 1973) is hereby repealed and the Appellate Board constituted under sub-section (1) of section 52 of the said Act (hereinafter referred to as the repealed Act) shall stand dissolved. (2) On the dissolution of the said Appellate Board, the person appointed as Chairman of the Appellate Board and every other person appointed as Member and holding office as such immediately before such date shall vacate their respective offices and no such Chairman or other person shall be entitled to claim any compensation for the premature termination of the term of his office or of any contract of service. (3) Notwithstanding anything contained in any other law for the time being in force, no court shall take cognizance of an offence under the repealed Act and no adjudicating officer shall take notice of any contravention under section 51 of the repealed Act after the expiry of a period of two years from the date of the commencement of this Act. (4) Subject to the provisions of sub-section (3) all offences committed under the repealed Act shall continue to be governed by the provisions of the repealed Act as if that Act had not been repealed. (5) Notwithstanding such repeal, (a) anything done or any action taken or purported to have been done or taken including any rule, notification, inspection, order or notice made or issued or any appointment, confirmation or declaration made or any licence, permission, authorization or exemption granted or any document or instrument executed or any direction given under the Act hereby repealed shall, in so far as it is not inconsistent with the provisions of this Act, be deemed to have been done or taken under the corresponding provisions of this Act; (b) any appeal preferred to the Appellate Board under sub-section (2) of section 52 of the repealed Act but not disposed of before the commencement of this Act shall stand transferred to and shall be disposed of by the Appellate Tribunal constituted under this Act;
40

(c) every appeal from any decision or order of the Appellate Board under sub-section (3) or sub-section (4) of section 52 of the repealed Act shall, if not filed before the commencement of this Act, be filed before the High Court within a period of sixty days of such commencement : Provided that the High Court may entertain such appeal after the expiry of the said period of sixty days if it is satisfied that the appellant was prevented by sufficient cause from filing the appeal within the said period. (6) Save as otherwise provided in sub-section (3), the mention of particular matters in subsections (2), (4) and (5) shall not be held to prejudice or affect the general application of section 6 of the General Clauses Act, 1897 (10 of 1897) with regard to the effect of repeal

41

INTRODUCTION TO FOREX - MAJOR CURRENCIES:

A) THE U.S. DOLLAR.

The United States dollar is the world's main currency an universal measure to evaluate any other currency traded on Forex. All currencies are generally quoted in U.S. dollar terms. Under conditions of international economic and political unrest, the U.S. dollar is the main safe-haven currency, which was proven particularly well during the Southeast Asian crisis of 1997-1998. As it was indicated, the U.S. dollar became the leading currency toward the end of the Second World War along the Breton Woods Accord, as the other currencies were virtually pegged against it. The introduction of the euro in 1999 reduced the dollar's importance only marginally. The other major currencies traded against the U.S. dollar are the euro, Japanese yen, British pound, and Swiss franc.

B) THE EURO.

The euro was designed to become the premier currency in trading by simply being quoted in American terms. Like the U.S. dollar, the euro has a strong international presence stemming from members of the European Monetary Union. The currency remains lagued by unequal growth, high unemployment, and government resistance to structural changes. The pair was also weighed in 1999 and 2000 by outflows from foreign investors, particularly Japanese, who were forced to liquidate their losing investments in euro-denominated assets. Moreover, European money managers rebalanced their portfolios and reduced their euro exposure as their needs for hedging currency risk in Europe declined.

42

C) THE JAPANESE YEN.

The Japanese yen is the third most traded currency in the world; it has a much smaller international presence than the U.S. dollar or the euro. The yen is very liquid around the world, practically around the clock. The natural demand to trade the yen concentrated mostly among the Japanese keiretsu, the economic and financial conglomerates. The yen is much more sensitive to the fortunes of the Nikkei index, the Japanese stock market, and the real estate market.

D) THE BRITISH POUND.

Until the end of World War II, the pound was the currency of reference. The currency is heavily traded against the euro and the U.S. dollar, but has a spotty presence against other currencies. Prior to the introduction of the euro, both the pound benefited from any doubts about the currency convergence. After the introduction of the euro, Bank of England is attempting to bring the high U.K. rates closer to the lower rates in the euro zone. The pound could join the euro in the early 2000s, provided that the U.K. referendum is positive.

E) THE SWISS FRANC.

The Swiss franc is the only currency of a major European country that belongs neither to the European Monetary Union nor to the G-7 countries. Although the Swiss economy is relatively small, the Swiss franc is one of the four major currencies, closely resembling the strength and quality of the Swiss economy and finance. Switzerland has a very close economic relationship with Germany, and thus to the euro zone. Therefore, in terms of political uncertainty in the East, the Swiss franc is favored generally over the euro. Typically, it is believed that the Swiss franc is a stable currency. Actually, from a foreign exchange point of view, the Swiss franc closely resembles the patterns of the euro, but lacks its liquidity. As the demand for it exceeds supply, the Swiss franc can be more volatile than the euro.

43

INTRODUCTION TO FOREX - CONCEPTS AND TERMINOLOGIES:

Here are some important concepts/terminologies of Forex.

A) SPOT RATE

A spot transaction is a straightforward (or outright) exchange of one currency for another. The spot rate is the current market price or 'cash' rate. Spot transactions do not require immediate settlement, or payment 'on the spot'. By convention, the settlement date, or value date, is the second business day after the deal date on which the transaction is made by the two parties. B) BID & ASK

In the foreign exchange market (and essentially in all markets) there is a buying and selling price. It is important to perceive these prices as a reflection of market condition. A market maker is expected to quote simultaneously for his customers both a price at which he is willing to buy (the bid) and a price at which he is willing to sell (the ask) standard amounts of any currency for which he is making a market. Generally speaking the difference between the bid and ask rates reflect the level of liquidity in a certain instrument. On a normal trading day, the major currency pairs EURUSD, USDJPY, USDCHF and GBPUSD are traded by a multitude of market participant every few seconds. High liquidity means that there is always a seller for your buy and a buyer for your sell at actual prices. C) BASE CURRENCY AND COUNTER CURRENCY Every foreign exchange transaction involves two currencies. It is important to keep straight which is the base currency and which is the counter currency. The counter currency is the numerator and the base currency is the denominator. When the counter currency increases, the base currency strengthens and becomes more expensive. When the counter currency decreases, the base currency weakens and becomes cheaper. In telephone trading communications, the base currency is always stated first. For example, a quotation for USDJPY means the US dollar is the base and the yen is the counter currency. In the case of GBPUSD (usually called 'cable') the British pound is the base and the US dollar is the counter currency.

44

D) QUOTES IN TERMS OF BASE CURRENCY

Traders always think in terms of how much it costs to buy or sell the base currency. When a quote of 1.1750 / 53 is given that means that a trader can buy EUR against USD at 1.1753. If he is buying EURUSD for 1'000'000 at that rate he would have USD 1,175,300 in exchange for his million Euro. Of course traders are not actually interested in exchanging large amounts of different currency, their main focus is to buy at a low rate and sell at higher one.

E) BASIS POINTS OR 'PIPS'

For most currencies, bid and offer quotes are carried down to the fourth decimal place. That represents one-hundredth of one percent, or 1/10,000th of the counter currency unit, usually called a 'pip'. However, for a few currency units that are relatively small in absolute value, such as the Japanese yen, quotes may be carried down to two decimal places and a 'pip' is 1/100th of the terms currency unit. In foreign exchange, a 'pip' is the smallest amount by which a price may fluctuate in that market.

F) EURO CROSS & CROSS RATES

Euro cross rates are currency pairs that involve the Euro currency versus another currency. Examples of Euro crosses are EURJPY, EURCHF and GBPEUR. Currency pairs that involve neither the Euro nor the US dollar are called cross rates. Examples of cross rates are GBPJPY and CHFJPY. Of course hundreds of cross rates exist involving exotic currency pairs but they are often plagued by low liquidity. Ever since the Euro the number of liquid cross rates have decreased and have been replaced (to a certain extent) by Euro crosses.

INTRODUCTION TO FOREX - PROFIT AND LOSS

Profit and Loss (P&L) for every position is calculated in real-time on most trading platforms. This enables traders to track their P&L tick by tick as the market fluctuates. Approximate USD values for a one (1) "pip" move per contract in our traded currency pairs are as follows, per 100,000 units of the base currency:
45

EURUSD 1 pip = 0.0001 1 pip move per 100k (lot) = EUR 100'000 x .0001 = USD 10.00 USDJPY 1 pip = 0.01 1 pip move per 100k (lot) = USD 100'000 x .01 = JPY 1'000 /spot = approx USD 9.7

USDCHF 1 pip = 0.0001 1 pip move per 100k (lot ) = USD 100'000 x .0001 = CHF 10.00 /spot = approx USD 8.5

GBPUSD 1 pip = 0.0001 1 pip move per 100k (lot ) = GBP 100'000 x .0001 = USD 10.00

EURJPY 1 pip = 0.01 1 pip move per 100k (lot ) = EUR 100'000 x .01 = JPY 1'000 /spot = approx. USD 9.7

EURCHF 1 pip = 0.0001 1 pip move per 100k (lot ) = EUR 100'000 x .0001 = CHF 10.00 /spot = approx. USD 8.5

EURGBP 1 pip = 0.0001 1 pip move per 100k (lot ) = EUR 100'000 x .0001 = GBP 10.00 /spot = approx. USD 19.00
46

USDCAD 1 pip = 0.0001 1 pip move per 100k (lot ) = USD 100'000 x .0001= CAD 10.00 /spot = approx. USD 8.00

AUDUSD 1 pip = 0.0001 1 pip move per 100k (lot ) = AUD 100'000 x .0001 = USD 10.00 On a typical day, liquid currency pairs like EUR/USD and USD/JPY can fluctuate a full point (.0100, 100 pips). On a EUR 1'000'000 position a full point on EUR/USD equates to 10'000 USD.

47

INTRODUCTION TO FOREX - UNDERSTANDING MARGINS:

Trading on a margined basis in foreign exchange is not a complicated concept as some may make it out to be. The easiest way to view margin trading is like this: Essentially when a trader trades on margin he is using a free short-term credit allowance from the institution that is offering the margin. This short-term credit allowance is used to purchase an amount of currency that greatly exceeds the account value of the trader. Let's take the following example: Example: Trader x has an account with EUR 50'00. He trades ticket sizes of 100'000 EUR/USD. This equates to a margin ratio of 2% (2000 is 2% of 100'000). How can trader x trade 50 times the amount of money he has at his disposal? The answer is that the OFB temporarily gives the necessary credit to make the transaction s/he is interested in making. Without margin, trader x would only be able to buy or sell tickets of 2000 at a time. On standard accounts OFB applies a minimum 2% margin. Margin serves as collateral to cover any losses that you might incur. Since nothing is actually being purchased or sold for delivery, the only requirement, and indeed the only real purpose for having funds in your account, is for sufficient margin.

B) LIMIT ORDER

An instruction to deal if a market moves to a more favorable level (i.e. an instruction to buy if a market goes down to a specified level or to sell if a market goes up to a specified level) is called a Limit Order. A Limit Order is often used to take profit on an existing position but can also be used to establish a new one. C) STOP ORDER

An instruction to deal if a market moves to a less favorable level (i.e. an instruction to buy if a market goes up to a specified level, or to sell if a market goes down to a specified level) is called a Stop Order. A Stop Order is often placed to put a cap on the potential loss on an existing position; which is why $ 500 (Commission $ 20) = $480 Stop Orders are sometimes called Stop-loss Orders. But can be used to enter into a new position if the market breaks a certain level. d) Once Cancels the Other (OCO)
48

An 'OCO' (One Cancels the Other) Order is a special type of Order where a Stop Order and a Limit Order in the same market are linked together. With an OCO Order, the execution of one of the two linked Orders results in the automatic cancellation of the other Order. e) IF DONE Order An IF DONE Order is a two-legged order in which the execution of the second leg can occur only after the conditions of the first leg have been satisfied. The first leg, either a Stop or a Limit, is created in an active state and the second, which can be a Stop, a Limit, or an OCO, is created in a dormant state. When the desired price is reached for the first leg, it is executed and the second leg is then activated.

CLEAR CONCEPT OF FOREIGN EXCHANGE

FOREIGN EXCHANGE

One of the largest businesses carried out by the commercial bank is foreign trading. The trade among various countries falls for close link between the parties dealing in trade. The situation calls for expertise in the field of foreign operations. The bank, which provides such operation, is referred to as rending international banking operation. Mainly transactions with overseas countries are respects of import; export and foreign remittance come under the preview of foreign exchange transactions. International trade demands a flow of goods from seller to buyer and of payment from buyer to seller. In this case the bank plays a vital role to bridge between the buyer and seller. H.E. Evitt defined Foreign Exchange as the means and methods by which rights to wealth expressed in terms of the currency of one country are converted into rights to wealth in terms of the currency of another country.

Foreign Exchange Department is an international department of the bank. It deals with globally and facilitates international trade through its various modes of services. It bridges between importers and exporters. Bangladesh Bank issues license to scheduled banks to deal with foreign exchange. These banks are known as Authorized Dealers. If the branch is authorized dealer in foreign exchange market, it can remit foreign exchange from local country to foreign country. This department mainly deals with foreign currency. This is why this department is called foreign exchange department.

49

Some national and international laws regulate functions of this department. Among these, Foreign Exchange Act, 1947 is for dealing in foreign exchange business, and Import and Export Control Act, 1950 is for Documentary Credits. Governments Import &Export policy is another important factor for import and export operation of banks. Foreign trade financing is an integral part of banking business. Documentary Credit (also called letters of credit or L/Cs) is the key player in the foreign exchange business. According to foreign exchange regulation Act, 1947, as adapted in Bangladesh, "Foreign exchange means foreign currency and includes all deposits, credit and balances payable in foreign currency as well as all foreign currency instruments, such as Drafts, Travelers cheques, Bills of Exchange and promissory notes payable in any foreign country. Anything that conveys a right to wealth in another country is foreign exchanges. With the globalization of economies international trade has become quite competitive. Timely payment for exports and quicker delivery of goods is, therefore, a pre-requisite for successful international trade operations. Growing complexity of international trade, separation of commercial parties across the globe and operating in a totally unknown environment underlined the need for evolving a system that balances between the expectations of the seller and the buyer. Documentary Credit has emerged as a vital system of trade payment, and fulfilled the requisite commercial need. This system substantially reduces payment-related risks for both exporter and importer. Not surprisingly, therefore, the letter of credit is the classic form of international export payment, especially in trade between distant partners. Payment, acceptance or negotiation of the credit is made by the bank upon presentation by the seller of stipulated documents (e.g., bill of lading, invoice, inspection certificate). Foreign exchange refers to the process or mechanism by which the currency of one country is converted into the currency of another country and thereby involves the international transfer of money. It is the means and method by which rights to wealth in a countrys currency are converted into rights to wealth in another countrys currency. In banks when we talk of foreign exchange, we refer to the general mechanism by which a bank converts currency of one country into that of another. Foreign trade gives rise to foreign exchange. Foreign trade is transacted either in the currency of the exporters country or that of the importers country, or that of a third country acceptable to both the exporter and the importer. DR. PAUL EINZIG
50

Foreign exchange is the system or process of converting one national currency into another and of transferring the ownership of money from one country to another.

MR. H. E. EVITT

Foreign exchange is that section of economic science which deals with the means and methods by which rights to wealth in one countrys currency are converted into rights to wealth in terms of another countrys currency. It involves the investigation of the method by which the currency of one country is exchanged for that of another, the causes which render such exchange necessary, the forms which in exchange may take and the ratios or equivalent values at which such exchanges are effected.

The term currency as earlier stated includes not only such notes and coins as are legal tenders, but also bank balances and deposits in foreign currency and all instruments- credit instruments which are capable of being used as currency, such as bills of exchange, promissory notes, letter of credit, travelers cheques, cheques, drafts, airmail transfers, telegraphic transfers (TT) and all other instruments which convey to holder a right to wealth. Thus foreign exchange means foreign currency and includes I. All deposits, credits and balances payable in any foreign currency and any drafts, travelers cheques, letters of credit and bills of exchange, expressed or drawn in local currency but payable in any foreign currency; and II. Any instrument payable, at the option of the drawee or holder thereof or any other party thereto, either in local currency or in foreign currency or party in one and party in the other. Foreign exchange is concerned with the settlement of international indebtedness, the methods of effecting the settlements and the instruments used in this connection, and the variation in the rates of exchange at which settlement of international indebtedness is made.
51

FOREIGN EXCHANGE RISK MANAGEMENT

1. THE SPOT RATE

Before we are able to deal with a problem we need to define it. Foreign exchange exposure comes in three forms, Translation, Economic and Transaction1. However before defining these further it may be useful to learn how to read foreign exchange rates. Take the following example Reading foreign exchange rates A Swiss based company has US dollars (SWIFT code USD) in a USD account in Switzerland that it needs to convert to Swiss Francs (CHF) as soon as possible. To do this it will execute a spot deal. A spot deal is a deal undertaken today at todays market rate. This rate, or price, in freely floating currencies, is a result of supply and demand. In normal circumstances, although it is todays rate, the actual settlement or cash flows take place two business days later. The bank quotes a spot rate as follows: USD / CHF one dollar 1.4224-1.4234 no. of Swiss francs

Exchange rates are usually quoted as numbers of the base currency to one unit of the nonbase currency. Sterling is usually an exception to this but not always. However do not worry about knowing when this is so as the way in which the rates are written in this book will tell you which is the unit one currency. It is the one written first. This is not a universal rule and you may come across different conventions. When dealing in the market, if in doubt, ask the dealer. There are also two rates quoted, one at which the bank will take the unit one currency from you and give you the other, and one at which the bank will kindly take the other currency off you and give you the unit one currency. An example will hopefully clarify. The company wishes to sell the USD, i.e. give dollars to the bank and receive a number of Swiss Francs in return. Knowing which of the two Swiss Franc numbers to use is easy if we remember two things. The first is that we will always take the perspective of the company and not that of the bank, i.e. we will always be the ones asking someone else to quote rates for us. We are market takers (the other party is the market maker). The second thing to remember is a simple rule that follows from point one above and this is, think cynical!

52

Now back to our quote above. One of the two numbers in Swiss Francs represents the numbers of Swiss Francs the bank will give you if you give them one dollar. Do you think they will give you the most or the least number of Swiss Francs in return for the dollar you give them? Correct the least, so we now know that if we give the bank one dollar they will give us 1.4224 Swiss Francs. Suppose then that the Swiss company wishes to sell USD 10,000,000. They will give the bank USD10,000,000 and will in return get CHF14,224,000 i.e. simply multiply the number of USD by 1.4224. Suppose a week later the Swiss company realizes it needs the ten million dollars again. It rings the bank for a spot quote and is given USD/CHF 1.4254 - 1.4264. FIRST QUESTION: HAS THE USD STRENGTHENED OR WEAKENED? The purpose of this question is just to get you to think about foreign exchange in different ways to develop a facility with it. You are correct, again, if you said strengthened. Why? because there are now more CHF to one USD than there were last time. SECOND QUESTION: HOW MANY CHF WILL WE NEED TO GIVE TO GET USD 10,000,000? First step:. To get one dollar from the bank, will we give the most or the least CHF spot? Correct, the most. We therefore know that to get one USD we need to give CHF1.4264. We need to get USD 10,000,000 so we will multiply USD 10,000,000 by 1.4264. We will have to give CHF14,264,000. NB. The two quotes are often referred to as the bid and offer i.e. the bid is the rate at which a bank will bid for the unit one currency and give the other currency and the offer is the rate at which the bank will sell you the one unit currency and take the other currency off you. The difference between these two rates is referred to as the bid offer spread, or side of the market spread. For example, in the quote USD/ CHF 1.4254 - 1.4264 the bid rate is 1.4254, the offer is 1.4264 and the bid-offer spread is 10 points. As we are not dealers we will continue to use give and get (and perhaps buy and sell).

53

READING FOREIGN EXCHANGE RATES. THE FORWARD

The same Swiss company knows that it will need to sell USD10,000,000 in three months time. To be certain of the rate it will get in three months, the Swiss Co wishes to fix the rate today through a forward contract. A forward is a rate agreed today at which two parties will exchange two currencies on a specified date in the future. To find the forward rate you again ring the bank to obtain a quotation. The bank will give you the spot quotation together with a set of points that need to be either added or subtracted from the spot rate. (Points are simply a result of applying the interest differential between the two currencies involved to the spot rate. How points are derived is explained in appendix 1.) To return to our example. The Swiss Co rings the bank and asks for a three month forward rate. Let us use the second spot quote used above. The bank will quote as follows: Spot USD/CHF 1.4254 - 1.4264 3 month Points 133-127 The Swiss Co wants to know what the forward outright rate is, or the rate written in full. To obtain this rate we have to either add or subtract points. Luckily there is a simple rule to follow. If points are high on the left low on the right

then subtract the points

If on the other hand, points are higher on the right lower on the left then add the points. In this case points are high, 133, on the left and
54

low127 on the right

so we subtract them to give the forward outright rate (hereafter referred to as the forward) Spot USD/CHF 3 month 1.4254 - 1.4264 133127

---------------------3 month forward 1.4121 - 1.4137

Now we follow the same process as before to know which is our rate for this particular transaction. We wish to know how many CHF we will receive for USD10,000,000. First which rate is ours? We will give one USD to get the most of the least CHF? Correct, the least, so we are on the left side or 1.4254 spot and 1.4121 is our forward rate. We will be giving USD10,000,000 so we will get CHF14,121,000. Again, just to round out our thinking on this, suppose that, rather than having to sell USD10,000,000, the Swiss Co had a specific number of CHF it needed to get, say CHF 23,000,000. The process for finding the current rate to use is the same, i.e. we know we will be giving USD to get CHF so we will give one USD get the least CHF or 1.4121. But we need CHF 23,000,000 so to find the number of USD necessary to produce this amount of CHF we divide 23,000,000 by 1.4121 to give USD16,287,798.31.

SOME MINOR COMPLICATIONS

Sterling (GBP)

55

Normally exchange rates are quoted as numbers of the base currency to one non-base. As shown above, as a Swiss Co we would expect to see a quote of USD/CHF 1.4254 - 1.4264 or numbers of CHF to one USD, or against GBP as numbers of CHF to one GBP i.e. GBP / CHF 2.3295 - 2.3306 one GBP numbers of CHF

Test: If the Swiss Co wishes to get one GBP how many CHF will it have to give? Answer: the most or 2.3306.

However, there are exceptions and GBP and often the USD are examples, as well as the Euro. In the UK we would also see GBP/CHF 2.3295 - 2.3306 as the quote, the same as above. one GBP numbers of CHF

But note, the currency that is written first is still the unit one currency, and the correct quote may still be found using the same rules as given above. Example 1. A UK company needs to purchase 10,000,000 Danish krone (DKK). The spot quote is GBP/DKK 10.8240 - 10.8255

Question: How many GBP will it need to give? Step 1: Ask yourself if the UK company gives the bank one GBP, will the bank give it the most or the least DKK? Answer: Think cynical (Please note that this is not meant to be a prescription for life, merely a guide to reading foreign exchange and money market rates!) and answer, the least. Step 2: You now know that you will get DKK10.8240 if you give the bank one GBP.
56

You need DKK 10,000,000 so to find how many GBP you will have to give in total divide 10,000,000 by 10.8240. Answer: GBP 923,872.88 Example 2 You are a UK company and are about to receive 10,000,000 Euros (EUR). You will sell these spot. The bank quotes: EUR/GBP 0.6358 - 0.6369 one Euro to numbers of GBP

This is about the only currency where the GBP is quoted this way, but notice the first currency quoted is the unit 1 currency. So, since you will be giving Euros (one) to get GBP, you will get the least so the spot is 0.6358, or a total of GBP 6,358,000. Question: A German company is due to receive GBP 15,000,000 which it will sell spot. How many Euros will it receive from the bank?

Step 1: Ask yourself if I wish to get one Euro will I have to give the bank the most or the least number of GBP? Answer: the most or 0.6369. You now know the rate, so to find out how many Euros you will receive if you give the bank GBP 15,000,000 divide 15,000,000 by 0.6369 = Euro 23,551,577.96 Note: You will also see the quote the other way around i.e. GBP/EUR. To convert the quote above just take the reciprocal (divide 1 by the number) and write them down with the lowest figure on the left.

EUR/GBP

0.6358 - 0.6369 1 1

0.6358 - 0.6369

GBP/EUR

1.5701 - 1.5728

You will see the quote in this way in the Financial Times as well as the other way and hear it quoted both ways on the Business News on the BBC Radio 4 Today Programme at 6.15 am and see it both ways in the Wall Street Journal (for the USD).
57

Example 3. The German Company wishes to buy GBP 7,500,000 one month forward and is quoted

Spot EUR/GBP One month points

0.6358 - 0.6369 12 14

----------------------------One month forward Note, points are Low on the left 0.6370 - 0.6383 High on the right so we added

Question: How many Euros will the German company have to give to get GBP 7,500,000? Answer: They will be giving one Euro so will get the least number of GBP, 0.6358 at spot plus 12 points to give 0.6370 as the forward. We know that one Euro will only produce 0.6370 GBP therefore we know we will need more than 7,500,000 Euro to produce GBP 7,500,000. Therefore we divide 7,500,000 by 0.6370 and that equals Euro 11,773,940.35.

Example 4. A US company is receiving Euro 10,000,000 in three months' time that it wishes to sell forward. The bank quotes the following Spot EUR/USD Three month Points 0.8686 - 0.8690 33 30

The company will be giving Euros (unit one currency) getting USD and is therefore on the left hand side of the market. Spot rate is 0.8686 and the forward 0.8653 (high- low subtract points) and will therefore receive USD8,653,000.

58

POINTS When a bank quotes points for a forward it usually just gives you two numbers i.e. as in the last quote 33-30, with no decimal place, as well as the spot rate. Always write them down by placing the last digit of the points, under the last digit of the spot quotation, i.e. as in the last quote the last three of 33 goes under the last 6 in 0.8686 to give 0.8686 33 Two things are worth pointing (no pun intended) out here: there is an implied, but not stated 0.00 in front of the 33; and every figure given by the dealer in the spot quote is important. Do not think zeroes have no meaning. Suppose the dealer quoted a spot rate of GBP/USD 1.4200 - 1.4210 and points of 46 40 We should write this as: GBP/USD 1.4200 - 1.4210 46 40

but DO NOT knock the zeroes off, because if you did there would be a danger of making the following mistake: 1.42 - 1.421 46 40

which is, quite simply, wrong Not every currency is quoted to four decimal places. For example the Japanese Yen is usually quoted to two decimal places. e.g. if spot was GBP/JPY 133.79 - 133.85 and six month points were given as 134 125 we would write it as follows: Spot GBP/JPY 6 Mo points 133.79 - 133.85 134 125

59

---------------------Six month forward 132.45 132.60

You will also come across situations where the dealer does quote you points with decimals. These are easy to handle if you just remember to follow the previous guidance. i.e. Spot GBP/USD 1.4200 - 1.4210 and forward points of 23.6 - 21.7. We simply put the last whole number of the points under the last numbers of the spot quote as follows: Spot GBP/USD 1 month points 1.4200 - 1.4210 236 217

--------------------------1 month forward 1.41764 1.41883

There are occasions when, rather than follow the High-Low subtract, Low-High add rule, we have to do what the dealer explicitly tells us to do, as in the GBP Thai Baht quote below Spot GBP/THB 1 month points 62.13 - 62.38 -18 - +27 -----------------------1 month forward 61.95 - 62.65

Note, as the dealer gave us a minus sign in front of the 18, we have subtracted these points and as there is a plus sign in front of the 27, we have added those points.

SUMMARY SO FAR

We have looked at two circumstances when a cash manager needs to use the foreign exchange market. These have involved a transfer of funds from one currency to another either
60

spot or forward and could be the result of a one off dividend payment or dividend receipt, or trade payment or trade receipt and so on. By now, hopefully, you are familiar with how foreign exchange rates are quoted. You will have seen some of the variations that may occur, but how, by following the same fundamental rules the right answer may be obtained. You will have learnt how to adjust the spot rate, by the points, to find what the forward outright rate is. We now need to use this knowledge in the context of managing foreign exchange risk.

FOREIGN EXCHANGE EXPOSURES DEFINED

Before we get into managing anything we need to know what it is we are managing and this means defining the problem. We also need to know that it is worth managing before we will spend time and money on the problem. As outlined above there are three sorts of FX risk and we will consider translation first.

TRANSLATION EXPOSURE

Translation exposure represents the effects, as reflected in the balance sheet and/or profit and loss account, of a movement in exchange rates between reporting dates on the translation of assets and liabilities denominated in foreign currencies. What does this mean? Well, any company that has overseas assets or liabilities or indeed any assets or liabilities denominated in a currency other than their reporting currency will have to translate those assets and liabilities into the companys reporting currency when the consolidated accounts have to be produced, at least twice a year. Almost certainly the foreign exchange rate between the countries involved will have changed over the intervening period and this will introduce movements in the balance sheet and profit and loss figures that have nothing to do with the underlying economic performance of the company. For example, suppose a UK based company purchases an American company. At the time of the purchase the exchange rate was GBP/USD 1.20 and the simplified balance sheet of the US company was as laid out below. Translating at that time into GBP gives a GBP balance sheet total of GBP100. A year goes by and quite by chance (to keep things simple) the US balance sheet has not changed but one thing has and that is the exchange rate that has moved to 1.50 i.e. the USD has weakened giving rise to the second GBP columns with GBP totals of GBP 80. Now the question is, has the UK company got a problem? The answer is of course, maybe. If we look at the shareholders funds we see that within one year shareholders funds have been reduced, in GBP terms, by GBP 3,000,000. This could be
61

considered careless of the management and that it is a problem. A counter argument is that it is only a translation effect and that next year the exchange rate might move back to 1.20 or even 1.1 and so no action is needed.

Different companies will have different attitudes towards this problem but by and large companies will not spend time and money manipulating the balance sheet for cosmetic reasons, as this is not considered a good use of shareholders funds. The exception may be where there are restrictive loan covenants. Restrictive loan covenants are conditions placed on the company when they borrow money and they are laid out in the loan documentation. Examples would be a restriction on dividend payouts until the loan is repaid or on maximum debt/ equity ratios. It is possible that, due to translation effects on the ratios, these covenants could be broken thus putting the company in default. If this happened then the bank or banks concerned could recall the loan. Where this is a real danger then companies might wish to manage the exposure.

ECONOMIC EXPOSURE: The risk that, long term, the relative appreciation in real terms, of the currency in which a companys major costs are denominated, will adversely affect that companys competitive position. Sometimes also called competitive exposure. An example is given below but first a bit of theory. The Purchasing Power Parity theory broadly states that a countrys foreign exchange rate against another country will move over time by the difference in inflation rates between the two countries. In other words the real exchange rate will stay the same . Now if this theory works then we would not have economic exposure but it does not, certainly in the short term. With this in mind work through the example below. Economic Exposure: An Example

CoA a Manufacturer in UK selling to France Inflation rate Current Price Current Exchange Rate Competitor in France Inflation Rate Current Price 2% p.a. EUR 153.7752 4% p.a. GBP 100 EUR/GBP.6503

62

At Year End

If PPP held UK Price French Price Therefore Exchange Rate GBP 104 EUR 156.85068 104 --------------156.85068 But if in reality the rate has moved to then UK Price of GBP 104 = Versus a French price of Or EUR 156.85 8.23 euros cheaper. EUR 165.08 EUR/GBP .6300 (100 x 1.04) (153.7752 x 1.02) = .6630509

Will Co A sell any goods in France (or England for that matter)?

The answer is of course, yes because the British goods will beat the French product, hands down, on quality, service and innovation. Bias and national pride apart, the real answer is, probably not. If it is a commodity type good with no real distinguishing features then price will rule the day. The next question is what can the UK company do about it? Part of the answer is given above i.e. try to differentiate. Another aspect will be how price elastic demand is? Are there any costs of switching suppliers? The UK company could change its cost base to that of the French company. The most extreme version of this would be to move lock stock and barrel to Paris (and a pretty good idea that is too).

63

In fact we are able to observe this type of strategy happening in the world around us all the time. This, though, is a long-term action and difficult to reverse quickly if FX rates shift back to where they were as they are likely to do! A less extreme way to shift cost base is to buy raw materials from the same source as (or cheaper than) the competitor. This raises the same issues around ability to switch suppliers as were discussed above. Another basic cost of input is finance and one strategy could have been to have borrowed euros, changed them into GBP and left the exposure open. How would this have worked?

Well as follows. Say cost of finance in GBP is 5% pa and in euros is 3%. The UK company needs GBP 10,000,000 for one year. At year-end would need to pay back GBP 10,000,000 x 1.05 = 10,500,000 Instead it borrows sufficient euros to raise GBP 10,000,000 at a spot rate of EUR/ GBP .6503 or 10,000,000 /.6503 = 15,377,518 At the end of the year the company will need to pay back 15,377,519 x .03 = 461,325.57 4 + 15,377,519 = 15,838,844. If the spot rate at that time is .63 then that will cost GBP 9,978,471.7 or GBP 521,529 less than funding in GBP. Very neat, but, what happens if the euro strengthens rather than weakens? Well clearly the opposite so the company would lose money. A basic question is should the company be taking this sort of risk? The answer is probably no. Economic exposure is difficult to deal with and it is insidious to the extent that some companies may not even recognize they have it. For example a company that buys all its inputs domestically and only sells domestically will still have economic exposure if any of its competitors are based overseas or have overseas inputs.

TRANSACTION EXPOSURE

Transaction exposure may be defined as any amount paid or received by a company in any currency other than that of the country in which that entity is resident. There are two elements of transaction exposure that need to be identified: i) The mismatch between costs of sales denominated in one currency and sales proceeds denominated in another, and

ii) The time lag between the date at which the sale price is set in terms of foreign currency and the date of receipt of the sales proceeds.

64

Because of these two elements, it is unlikely that the amount of base currency paid or received in the future will be the same as if the transaction had occurred today. Transaction risk has very real and obvious impacts. Take a UK exporter who sold goods denominated in USD, say USD 1,000,000 with payment due in six months. On the day the sale was agreed the spot rate was GBP/USD 1.4553 1.4563. 1st question: How many pounds would they have received if the deal were to be done spot on the sale date? Answer. The UK company will be giving USD to get one GBP, therefore they will have to give the most USD therefore the rate which is theirs is 1.4563, therefore they would receive GBP 686,671.70. However they wait and instead sell the dollars spot six months later when the exchange rate has moved to GBP/USD 1.8970 1.8980. 2nd question: Has the pound weakened or strengthened? Answer. Strengthened, as one pound will now produce more USD. This also means that the USD has weakened so we now need more USD to produce one GBP. 3rd question: How many GBP will be received at the new spot rate? Answer. GBP 526,870.38 or GBP 159,801.32 less. This is a real loss to the company.

SUMMARY

Companies may be faced with three types of foreign exchange exposure. Translation exposure which, because it is not a realized gain or loss, tends not to have too much management time and expense spent on managing it. However where the effects are seen to be too damaging either on EPS or covenants then some management time may be justified. Economic exposure (sometimes called competitive) that is outside of the control of individual companies and is a consequence of the movement in exchange rates making goods relatively more or less expensive. It can be difficult to define and the impact can also be difficult to quantify. Remedies tend to involve strategic decisions that, while involving Treasury input, should not be made by the treasury department. Transaction exposure that involves real cash flows arising from day to day trading and financing activities. These may have an instantaneous and very visible effect and so occupy a large part of the treasurers attention. We now need to consider therefore how, assuming we wish to, we might manage transaction exposure.

65

MANAGING FOREIGN EXCHANGE RISK

As evidenced in recent years, the value of the Canadian dollar is unpredictable over time. The profitability of exporters and importers has taken a hit from the loonies fluctuations. However, the impact our dollar has on business profitability can be reduced by what is referred to as foreign exchange risk management. In fact, numerous trends are increasingly forcing Canadians to consider foreign exchange risk management, notably, globalization and market interdependence. The first should come as no surprise given that in the past, few companies had the opportunity to open their doors to the rest of the world. Today, a vast number of them are doing business internationally. Such is the case for many SMEs, which are trying to leverage free trade between Canada, the U.S. and Mexico. Indeed, these SMEs are growing faster by selling goods and services abroad or by importing less costly raw materials and better quality parts. Consequently, since the early 90s, Canadian businesses have become more interested in international currency trading. The second trend, market interdependence, is due to the fact that currency markets can generate chain reactions that affect the value of the Canadian dollar. The perfect example is rising oil prices caused by widespread and excessive uncertainty and speculation about the U.S. dollar. Since Canada has little influence on the level of confidence of the main players on the international monetary market, it is therefore wise for Canadian companies to take control of foreign exchange risk. The purpose of this guide is to familiarize you with this risk and explain the various hedging options available to offset it. The Desjardins International Service Centre can help you develop strategies in this regard. The last section provides the contact information for the international services development managers in the different regions of Canada.

STEP 1: DEFINING YOUR NEEDS

66

Based on the situation, you will have to determine whether you need to hedge and, if so, which instrument is the most appropriate. Answering the following questions may make it easier for you to decide: In relation to sales, what percentage of your receivables and/or payables is in foreign currency? How sensitive is your company to foreign exchange fluctuations, and at which point will the exchange rate affect your profitability? Can you match the due dates of your receivables and payables in a given currency? Are your export amounts and dates totally accurate? Can you pass on a currency loss to your customers by increasing prices? Do you have major investments to make in the short term (Do you need a stable cash flow?) or will you be making equipment or other purchases abroad in the short term? Can you reach an agreement with your customers to share foreign exchange risk both in terms of losses and gains?

Based on your answers to these questions, go to Step 2 to decide what is right for you.

STEP 2: HEDGING OVERVIEW Managing foreign exchange risk involves taking the appropriate measures to eliminate or hedge against these risks. You can therefore choose one of the following three policies based on the needs defined in Step 1. You decide not to act and accept the foreign exchange risk. However, in so doing, you are adopting a potentially risky position. For a company, not hedging is generally based on a misunderstanding of the risk or on the hope that it will gain from it. This lack of control (deliberate or not) can have unfortunate consequences on the companys profitability. Of course, hedging is not necessary if international transactions make up just a small part of your business. In short, if the percentage of your foreign currency receivables and/or payables is very low in relation to sales, or if, for example, you can match the due date of your receivables and payables in a given currency, you do not need to think about hedging.

SELECTIVE HEDGING In this case, you adopt a policy that sets out when and how you hedge against foreign exchange risk; for instance, you decide to hedge only some of your foreign transactions. This policy assumes that you have determined your risk tolerance and that you have an idea as to
67

the direction the currency in question will take. You can also adopt the principle that any hedging resulting in a plus or minus value of x dollars must be closed (profits or losses taken). Selective hedging can be illustrated with the following example. Let us assume 80% of your revenues or receivables are generated in the U.S. In this case, you could decide to hedge only half of these accounts with a hedging strategy. One of the reasons for doing so might be your expectations regarding short-term exchange rates. In fact, assuming that all your receivables are due within the next three months and that your foreign exchange expectations for the same period are to your advantage, you could decide to cover only half of these receivables. Here again, this strategy depends on the business needs defined in Step 1.
SYSTEMATIC HEDGING

This involves automatically hedging as soon as foreign currency commitments or assets are involved. In reality, very few companies fully hedge their position. As a general rule, the more a company relies on foreign exchange cash flow to grow or pay its debts, the more it will hedge against risk.

STEP 3: SELECTING CURRENCY INSTRUMENTS

The following is a brief description of the various instruments that exist to reduce the impact of foreign exchange fluctuations. A) Natural position The natural position is the company's fundamental position. It determines the companys exposure to a certain currency. Every company that conducts business transactions in a foreign currency has a natural position. However, natural hedging is a situation in which the companys operations are covered against foreign exchange risk. For example, this type of risk is not a factor when a company uses an inflow of U.S. currency to pay a supplier the equivalent amount in the same currency.

B) Forward contracts: foreign exchange forward contracts and swaps The forward contract is an instrument of choice for hedging against foreign exchange risk, offering flexibility and liquidity in the current currencies.
68

The amount and dates can be matched with a commercial transaction, thus eliminating any residual risk. Conversely, forward contracts do not allow a company to benefit from favorable currency moves. 1) The foreign exchange forward contract is an agreement to convert one currency into another. The amount of the transaction, the exchange rate used for the conversion and the future date on which the conversion will be made are fixed when the contract is purchased. Certain contracts allow partial deliveries made during an optional period that can reach 30 days. 2) The swap involves simultaneous spot and period transactions of one currency against another. This type of currency transaction is frequently used by companies with receivables and payables in the same currency, but whose due dates are not matched.

C) Call and put options:

By paying a premium, the option gives you the right but not the obligation to buy or sell\ currencies at a predetermined date and rate. The option (used for hedging and not speculative purposes) acts as a form of insurance policy, allowing you to make a profit when exchange rates shift in your favor and protect you when the opposite occurs. 1) Call option: Two scenarios are possible with call options. In the first, the exchange rate when the option expires is above the strike price, and the option holder can therefore exercise his right and purchase the currency at the predetermined advantageous rate. In the second scenario, the exchange rate on expiration of the option is below the strike price, and the holder therefore has no advantage in exercising this right, because he can purchase the currency at a lower price on the market. As a result, he only loses the premium paid when purchasing the option. 2) Put option: Two scenarios are also possible with put options. In the first, the exchange rate when the option expires is above the strike price, and the holder has no interest in selling at the strike price because he can do better on the market. The premium he paid initially is therefore lost. In the second, the exchange rate on expiration of the option is below the strike price, and it is therefore in the holders interest to exercise this option, because he can sell the currency at the strike price, which is advantageous.

D) Other options

69

Other options are available and are offered by our currency traders. In fact, a varied range of options adapted to the needs of each company is available. The advantage of foreign exchange risk hedging products is their flexibility. A customized strategy is always possible, and there are no limits to the possibilities. Here are a few examples of options available on the market. Collar: A collar is a combination of two contracts to obtain a very specific profit diagram. There are two ways to create a collar. The first involves buying a call option and selling a put option, while the second involves buying a put option and selling a call option. In both cases, the company guarantees that its purchase or selling price of U.S. currency will not go beyond a range between the two strike prices of the options in the collar. The price of this structure is generally equivalent to the amount paid to buy one of the options less the price received for selling the second option. Zero cost collar: This is the same principle as a regular collar but the structure is redesigned to ensure that the price of the option is zero. However, to do so, the holder must sacrifice a part of the potential gain so as to receive a greater premium on the option sold. Consequently, the holder guarantees that his exchange rate will be limited to a certain range, but the potential gain will be lower. Example of a zero cost collar: A company exporting medications to Europe wishes to protect itself against a depreciation of the euro but does not want to disburse any funds. This company has a variable amount of euros in its portfolio. Assume that the euro is currently trading at 1.45 for the purpose of the example. To meet its specific requirements, the company decides to use a zero cost collar as the hedging strategy. It purchases a three-month put option at a strike price of 1.4350 and sells a three-month call option to the Caisse centrale Desjardins at a strike price of 1.4650. The premium on the option purchased is $1,500, and the premium received on the option sold is $1,500. Consequently, the structure entails zero cost for the company. The company therefore succeeds in guaranteeing that the selling price of the euros will not go beyond the range of (1.4350-1.4650) for a period of three months, thus eliminating a source of risk.

Barrier options: These options have the same characteristics as standard options but include barriers. The barrier can be above or below the actual currency price and may be knock-in or knock-out.

70

Knock-in: A knock-in feature causes the option to become effective only if the currency price first reaches a specified barrier level. Knock-out: A knock-out feature causes the option to immediately terminate if the currency price reaches a specified barrier level.

In both cases, the currency price can reach or exceed the barrier any time before expiry to knock in/knock out the option.

Table 1: Pros and cons of forward exchange contracts and options

Forward Exchange contract

Swap Allows you to match inflows and outflows in a given currency Minimal cost $20,000 minimum Cannot benefit from a favorable currency move Guarantees may be required Cannot be cancelled except by taking a reverse position

Option Insurance policy: allows you to hedge against risk while benefiting from a favorable currency move $20,000 minimum

Pros / Benefits

Price known at time of hedging $20,000 minimum Minimal cost Hedging periods of two days to one year (longer term possible)

Cons / Risks

Cannot benefit from a favorable currency move Guarantees may be required Cannot be cancelled except by taking a reverse position

Premium required: varies based on such factors as the option term and foreign exchange volatility

Table 2: Pros and cons of other options

71

Collar Strong gain potential Limited loss potential Lower premium than when only one option is considered

Zero-cost collar

Barrier options

Pros / Benefits

Minimal cost Hedging periods of two days to one year (longer term possible)

Good gain potential Limited loss potential No premium to pay

Same pros as a standard option Lower premium

Cons / Risks

Capped gain potential Guarantees may be required

Capped gain potential Guarantees may be required

Imperfect hedging

72

STRATEGY OPTIONS Depending on the answers you gave in Step 1, the financial situation of your company (ability to take risks) and your own risk tolerance, here are a few examples of generic strategies. Other more complex strategies, as seen in point D, are also available to meet specific situations.

Table 3: Examples of possible strategies Desjardins Suggests Forward contract

Corporate Objective Setting the future price of my currencies today. Optimize the management of my multi-currency cash flow Ensure a minimum/maximum price while benefiting from a favorable currency move. Ensure a ceiling and floor price on the currency in order to effectively manage my cash flow.

Swap Currency option

Collar

STEP 4: KEEPING YOUR STRATEGY UP-TO-DATE

Once you have determined the right instruments for your needs, you need to decide on the hedge period. Three months is usually sufficient, but you may feel that one year is more appropriate. Here again, it is up to you to determine the period that will be covered by your foreign exchange risk hedging strategy. However, you should know that any strategy you devise may need redesigning. The data used to establish your strategy will change over time. For example, your receivables and payables may no longer be the same, you may now have a better natural hedge, or you may have different attitude to risk. In any case, a winning strategy must be revisited as often as possible to make sure it remains focused on your growth objectives, cash flow management and the current situation. The foreign exchange risk hedging products presented in this document are but a few of the many options available. The Caisse centrale Desjardins also offers many other possibilities not covered in this reference guide. We develop customized solutions because we know that each companys financial situation is unique.
73

he Desjardins International Service Centre and its team of international service development managers are here to handle your requests and answer your questions on this topic. Our team of currency traders is another important resource to help you find the right solution. Desjardins provides you with all the tools you need to make smart decisions that will help your company succeed.

PROCESS & NECESSITY FOR FOREIGN EXCHANGE RISK MANAGEMENT:

Firms dealing in multiple currencies face a risk (an unanticipated gain/loss) on account of sudden/unanticipated changes in exchange rates, quantified in terms of exposures. Exposure is defined as a contracted, projected or contingent cash flow whose magnitude is not certain at the moment and depends on the value of the foreign exchange rates. The process of identifying risks faced by the firm and implementing the process of protection from these risks by financial or operational hedging is defined as foreign exchange risk management. This paper limits its scope to hedging only the foreign exchange risks faced by firms.

FOREIGN EXCHANGE RISK MANAGEMENT:

Foreign exchange (FX) is a risk factor that is often overlooked by small and medium-sized enterprises (SMEs) that wish to enter, grow, and succeed in the global market- place. Although most U.S. SME exporters prefer to sell in U.S. dollars, creditworthy foreign buyers today are increasingly demanding to pay in their local currencies. From the viewpoint of a U.S. exporter who chooses to sell in foreign currencies, FX risk is the exposure to potential financial losses due to devaluation of the foreign currency against the U.S. dollar. Obviously, this exposure can be avoided by insisting on selling only in U.S. dollars. However, such an approach may result in losing export opportunities to competitors who are willing to accommodate their foreign buyers by selling in their local currencies. This approach Applicability could also result in the non-payment by a foreign buyer who may find it impossible to meet U.S. dollar-denominated payment obligations due to the devaluation of the local currency against the U.S.dollar While coverage for their local currencies. nonpayment could be covered by export credit insurance, such what-if protection is meaningless if export opportunities are lost in the first place because of the payment in U.S. dollars only policy. Selling in foreign currencies, if FX risk is successfully managed or hedged, can be a viable is used. option for U.S. exporters who wish to enter and remain competitive in the global marketplace.
74

KEY POINTS

Most foreign buyers generally prefer to trade in their local currencies to avoid FX risk exposure. U.S. SME exporters who choose to trade in foreign currencies can minimize FX exposure by using one of the widely-used FX risk management techniques available in the United States.

The volatile nature of the FX market poses a great risk of sudden and drastic FX rate movements, which may cause significantly damaging financial losses from otherwise profitable export sales.

The primary objective of FX risk management is to minimize potential currency losses, not to make a profit from FX rate movements, which are unpredictable and frequent.

FX RISK MANAGEMENT OPTIONS:

A variety of options are available for reducing short-term FX exposure. The following sections list FX risk management techniques considered suitable for new-to-export U.S. SME companies. The FX instruments mentioned below are available in all major currencies and are offered by numerous commercial lenders. However, not all of these techniques may be available in the buyers country or they may be too expensive to be useful.

75

NON-HEDGING FX RISK MANAGEMENT TECHNIQUES:

The exporter can avoid FX exposure by using the simplest non-hedging technique: price the sale in a foreign currency. The exporter can then demand cash in advance, and the cur- rent spot market rate will determine the U.S. dollar value of the foreign proceeds. A spot transaction is when the exporter and the importer agree to pay using todays exchange rate and settle within two business days. Another non-hedging technique is to net out foreign currency receipts with foreign currency expenditures. For example, the U.S. exporter who exports in pesos to a buyer in Mexico may want to purchase supplies in pesos from a different Mexican trading partner. If the companys export and import transactions with Mexico are comparable in value, pesos are rarely converted into dollars, and FX risk is minimized. The risk is further reduced if those peso-denominated export and import transactions are conducted on a regular basis.

FX FORWARD HEDGES:

The most direct method of hedging FX risk is a forward contract, which enables the exporter to sell a set amount of foreign currency at a pre-agreed exchange rate with a delivery date from three days to one year into the future. For example, suppose U.S. goods are sold to a Japanese company for 125 million yen on 30-day terms and that the forward rate for 30-day yen is 125 yen to the dollar. The U.S. exporter can eliminate FX exposure by contracting to deliver 125 million yen to his bank in 30 days in exchange for payment of $1 million dollars. Such a forward contract will ensure that the U.S. exporter can convert the 125 million yen into $1 million, regardless of what may happen to the dollar-yen exchange rate over the next 30 days. However, if the Japanese buyer fails to pay on time, the U.S. exporter will be obligated to deliver 125 million yen in 30 days. Accordingly, when using forward contracts to hedge FX risk, U.S. exporters are advised to pick forward delivery dates conservatively. If the foreign currency is collected sooner, the exporter can hold on to it until the delivery date or can swap the old FX contract for a new one with a new delivery date at a minimal cost. Note that there are no fees or charges for forward contracts since the lender hopes to make a spread by buying at one price and selling to someone else at a higher price.

76

FX OPTIONS HEDGES:

If there is serious doubt about whether a foreign currency sale will actually be completed and collected by any particular date, an FX option may be worth considering. Under an FX option, the exporter or the option holder acquires the right, but not the obligation, to deliver an agreed amount of foreign currency to the lender in exchange for dollars at a specified rate on or before the expiration date of the option. As opposed to a forward con- tract, an FX option has an explicit fee, which is similar to a premium paid for an insurance policy. If the value of the foreign currency goes down, the exporter is protected from loss. On the other hand, if the value of the foreign currency goes up significantly, the exporter can sell the option back to the lender or simply let it expire by selling the foreign currency on the spot market for more dollars than originally expected, but the fee would be forfeited. While FX options hedges provide a high degree of flexibility, they can be significantly more costly than FX forward hedges.

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.
77

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 centre or profit centre basis. A cost centre 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 centre approach on the 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--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.

78

FIGURE 1: FRAMEWORK FOR RISK MANAGEMENT

79

HEDGING STRATEGIES / INSTRUMENTS:

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.

FORWARDS: A forward is a made-to-measure agreement between two parties to buy/sell a specified amount of a currency at a specified rate on a particular date in the future. The depreciation of the receivable currency is hedged against by selling a currency forward. If the risk is that of a currency appreciation (if the firm has to buy that currency in future say for import), it can hedge by buying the currency forward. E.g. if RIL wants to buy crude oil in US dollars six months hence, it can enter into a forward contract to pay INR and buy USD and lock in a fixed exchange rate for INR-USD to be paid after 6 months regardless of the actual INR-Dollar rate at the time. In this example the downside is an appreciation of Dollar which is protected by a fixed forward contract. The main advantage of a forward is that it can be tailored to the specific needs of the firm and an exact hedge can be obtained. On the downside, these contracts are not marketable, they cant be sold to another party when they are no longer required and are binding. FUTURES: A futures contract is similar to the forward contract but is more liquid because it is traded in an organized exchange i.e. the futures market. Depreciation of a currency can be hedged by selling futures and appreciation can be hedged by buying futures. Advantages of futures are that there is a central market for futures which eliminates the problem of double coincidence. Futures require a small initial outlay (a proportion of the value of the future) with which significant amounts of money can be gained or lost with the actual forwards price fluctuations. This provides a sort of leverage. The previous example for a forward contract for RIL applies here also just that RIL will have to go to a USD futures exchange to purchase standardized dollar futures equal to the amount to be hedged as the risk is that of appreciation of the dollar. As mentioned earlier, the tailor

80

ability of the futures contract is limited i.e. only standard denominations of money can be bought instead of the exact amounts that are bought in forward contracts. OPTIONS: A currency Option is a contract giving the right, not the obligation, to buy or sell a specific quantity of one foreign currency in exchange for another at a fixed price; called the Exercise Price or Strike Price. The fixed nature of the exercise price reduces the uncertainty of exchange rate changes and limits the losses of open currency positions. Options are particularly suited as a hedging tool for contingent cash flows, as is the case in bidding processes. Call Options are used if the risk is an upward trend in price (of the currency), while Put Options are used if the risk is a downward trend. Again taking the example of RIL which needs to purchase crude oil in USD in 6 months, if RIL buys a Call option (as the risk is an upward trend in dollar rate), i.e. the right to buy a specified amount of dollars at a fixed rate on a specified date, there are two scenarios. If the exchange rate movement is favorable i.e. the dollar depreciates, then RIL can buy them at the spot rate as they have become cheaper. In the other case, if the dollar appreciates compared to todays spot rate, RIL can exercise the option to purchase it at the agreed strike price. In either case RIL benefits by paying the lower price to purchase the dollar. SWAPS: A swap is a foreign currency contract whereby the buyer and seller exchange equal initial 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 over the term of the contract. At maturity, the principal amount is effectively re-swapped at a predetermined exchange rate so that the parties end up with their original currencies. The advantages of swaps are that firms with limited appetite for exchange rate risk may move to a partially 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 oriented company that has entered into a swap for a notional principal of USD 1 mn at an exchange rate of 42/dollar. The company pays US 6months LIBOR to the bank and receives 11.00% p.a. every 6 months on 1st January & 1st July, till 5 years. Such a company would have earnings in Dollars and can use the same to pay interest for this kind of borrowing (in dollars rather than in Rupee) thus hedging its exposures.

81

 FOREIGN DEBT: Foreign debt can be used to hedge foreign exchange exposure by taking advantage of the International Fischer Effect relationship. This is demonstrated with the example of an exporter who has to receive a fixed amount of dollars in a few months from present. The exporter stands to lose if the domestic currency appreciates against that currency in the meanwhile so, to hedge this, he could take a loan in the foreign currency for the same time period and convert the same into domestic currency at the current exchange rate. The theory assures that the gain realized by investing the proceeds from the loan would match the interest rate payment (in the foreign currency) for the loan.

CHOICE OF HEDGING INSTRUMENTS:

The literature on the choice of hedging instruments is very scant. Among the available studies, Gczy et al. (1997) argues that currency swaps are more cost-effective for hedging foreign debt risk, while forward contracts are more cost-effective for hedging foreign operations risk. This is because foreign currency debt payments are long-term and predictable, which fits the long-term nature of currency swap contracts. Foreign currency revenues, on the other hand, are short-term and unpredictable, in line with the short-term nature of forward contracts. A survey done by Marshall (2000) also points out that currency swaps are better for hedging against translation risk, while forwards are better for hedging against transaction risk. This study also provides anecdotal evidence that pricing policy is the most popular means of hedging economic exposures. These results however can differ for different currencies depending in the sensitivity of that currency to various market factors. Regulation in the foreign exchange markets of various countries may also skew such results. 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 elements of exchange rate uncertainty and the attitude toward risk are irrelevant to the multinational firm's sales and production
82

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 firms 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 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) 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 value of assets is used as a measure of firm size. Leverage:

83

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. 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. quick assets divided by current liabilities). Profitability is measured as EBIT divided by book 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 is obtained using the 3-year geometric average of yearly sales growth rates. As regards the degree of hedging Allayanis and Ofek (2001) conclude that the sole determinants of the degree of hedging are exposure factors (foreign sales and trade). In other words, given that a firm decides to hedge, the decision of how much to hedge is affected solely by its exposure to foreign currency movements. This discussion highlights how risk management systems have to be altered according to characteristics of the firm, hedging costs, nature of operations, tax considerations, regulatory requirements etc. The next section discusses these issues in the Indian context and regulatory environment.

84

CORPORATE HEDGING: TOOLS AND TECHNIQUES

TOOLS AND TECHNIQUES FOR THE MANAGEMENT OF FOREIGN EXCHANGE RISK In this article we consider the relative merits of several different tools for hedging exchange risk, including forwards, futures, debt, swaps and options. We will use the following criteria for contrasting the tools. First, there are different tools that serve effectively the same purpose. Most currency management instruments enable the firm to take a long or a short position to hedge an opposite short or long position. Thus one can hedge a Euro payment using a forward exchange contract, or debt in Euro, or futures or perhaps a currency swap. In equilibrium the cost of all will be the same, according to the fundamental relationships of the international money market. They differ in details like default risk or transactions costs, or if there is some fundamental market imperfection. indeed in an efficient market one would expect the anticipated cost of hedging to be zero. This follows from the unbiased forward rate theory. Second, tools differ in that they hedge different risks. In particular, symmetric hedging tools like futures cannot easily hedge contingent cash flows: options may be better suited to the latter. Tools and techniques: foreign exchange forwards Foreign exchange is, of course, the exchange of one currency for another. Trading or "dealing" in each pair of currencies consists of two parts, the spot market, where payment (delivery) is made right away (in practice this means usually the second business day), and the forward market. The rate in the forward market is a price for foreign currency set at the time the transaction is agreed to but with the actual exchange, or delivery, taking place at a specified time in the future. While the amount of the transaction, the value date, the payments procedure, and the exchange rate are all determined in advance, no exchange of money takes place until the actual settlement date. This commitment to exchange currencies at a previously agreed exchange rate is usually referred to as a forward contract. Forward contracts are the most common means of hedging transactions in foreign currencies. The trouble with forward contracts, however, is that they require future
85

performance, and sometimes one party is unable to perform on the contract. When that happens, the hedge disappears, sometimes at great cost to the hedger. This default risk also means that many companies do not have access to the forward market in sufficient quantity to fully hedge their exchange exposure. For such situations, futures may be more suitable. Currency futures Outside of the interbank forward market, the best-developed market for hedging exchange rate risk is the currency futures market. In principle, currency futures are similar to foreign exchange forwards in that they are contracts for delivery of a certain amount of a foreign currency at some future date and at a known price. In practice, they differ from forward contracts in important ways. One difference between forwards and futures is standardization. Forwards are for any amount, as long as it's big enough to be worth the dealer's time, while futures are for standard amounts, each contract being far smaller than the average forward transaction. Futures are also standardized in terms of delivery date. The normal currency futures delivery dates are March, June, September and December, while forwards are private agreements that can specify any delivery date that the parties choose. Both of these features allow the futures contract to be tradable. Another difference is that forwards are traded by phone and telex and are completely independent of location or time. Futures, on the other hand, are traded in organized exchanges such the LIFFE in London, SIMEX in Singapore and the IMM in Chicago. But the most important feature of the futures contract is not its standardization or trading organization but in the time pattern of the cash flows between parties to the transaction. In a forward contract, whether it involves full delivery of the two currencies or just compensation of the net value, the transfer of funds takes place once: at maturity. With futures, cash changes hands every day during the life of the contract, or at least every day that has seen a change in the price of the contract. This daily cash compensation feature largely eliminates default risk. Thus forwards and futures serve similar purposes, and tend to have identical rates, but differ in their applicability. Most big companies use forwards; futures tend to be used whenever credit risk may be a problem.

Debt instead of forwards or futures Debt -- borrowing in the currency to which the firm is exposed or investing in interestbearing assets to offset a foreign currency payment -- is a widely used hedging tool that

86

serves much the same purpose as forward contracts. Consider an example. A German company has shipped equipment to a company in Calgary, Canada. The exporter's treasurer has sold Canadian dollars forward to protect against a fall in the Canadian currency. Alternatively she could have used the borrowing market to achieve the same objective. She would borrow Canadian dollars, which she would then change into Euros in the spot market, and hold them in a Euro deposit for two months. When payment in Canadian dollars was received from the customer, she would use the proceeds to pay down the Canadian dollar debt. Such a transaction is termed a money market hedge. The cost of this money market hedge is the difference between the Canadian dollar interest rate paid and the Euro interest rate earned. According to the interest rate parity theorem, the interest differential equals the forward exchange premium, the percentage by which the forward rate differs from the spot exchange rate. So the cost of the money market hedge should be the same as the forward or futures market hedge, unless the firm has some advantage in one market or the other. The money market hedge suits many companies because they have to borrow anyway, so it simply is a matter of denominating the company's debt in the currency to which it is exposed. that is logical. but if a money market hedge is to be done for its own sake, as in the example just given, the firm ends up borrowing from one bank and lending to another, thus losing on the spread. This is costly, so the forward hedge would probably be more advantageous except where the firm had to borrow for ongoing purposes anyway. Currency options Many companies, banks and governments have extensive experience in the use of forward exchange contracts. With a forward contract one can lock in an exchange rate for the future. There are a number of circumstances, however, where it may be desirable to have more flexibility than a forward provides. For example a computer manufacturer in California may have sales priced in U.S. dollars as well as in Euros in Europe. Depending on the relative strength of the two currencies, revenues may be realized in either Euros or dollars. In such a situation the use of forward or futures would be inappropriate: there's no point in hedging something you might not have. What is called for is a foreign exchange option: the right, but not the obligation, to exchange currency at a predetermined rate. A foreign exchange option is a contract for future delivery of a currency in exchange for another, where the holder of the option has the right to buy (or sell) the currency at an agreed price, the strike or exercise price, but is not required to do so. The right to buy is a call; the right to sell, a put. For such a right he pays a price called the option premium. The option seller receives the premium and is obliged to make (or take) delivery at the agreedupon price if the buyer exercises his option. In some options, the instrument being delivered
87

is the currency itself; in others, a futures contract on the currency. American options permit the holder to exercise at any time before the expiration date; European options, only on the expiration date.

Example Shinji Yamamoto of Nippon Foods had just agreed to purchase AUD 5 million worth of potatoes from his supplier in Australia. Payment of the five million Australian dollars was to be made in 245 days' time. The Japanese yen had recently fallen against foreign currencies and Yamamoto wanted to avoid any further rise in the cost of imports. He viewed the Australian dollar as being extremely instable in the current environment of economic tensions. Having decided to hedge the payment, he had obtained AUD/JPY quotes of AUD0.050 spot, AUD0.045 for 245 days forward delivery. His view, however, was that the yen was bound to rise in the next few months, so he was strongly considering purchasing a call option instead of buying the Australian currency forward. At a strike price of $0.045, the best quote he had been able to obtain was from the Bank of Melbourne, who would charge a premium of 0.85% of the principal. Yamamoto decided to buy the call option. In effect, he reasoned, I'm paying for downside protection while not limiting the possible savings I could reap if the yen does recover to a more realistic level. In a highly volatile market where crazy currency values can be reached, options make more sense than taking your chances in the market, and you're not locked into a rock-bottom forward rate.

This simple example illustrates the lopsided character of options. Futures and forwards are contracts in which two parties oblige themselves to exchange something in the future. They are thus useful to hedge or convert known currency or interest rate exposures. An option, in contrast, gives one party the right but not the obligation to buy or sell an asset under specified conditions while the other party assumes an obligation to sell or buy that asset if that option is exercised.

When should a company like Frito-Lay use options in preference to forwards or futures? In the example, Yamamoto had a view on the currency's direction that differed from the forward rate. Taken alone, this would suggest taking a position. But he also had a view on
88

the yen's volatility. Options provide the only convenient means of hedging or positioning "volatility risk." Indeed the price of an option is directly influenced by the outlook for a currency's volatility: the more volatile, the higher the price. To Yamamoto, the price is worth paying. In other words he thinks the true volatility is greater than that reflected in the option's price. This example highlights one set of circumstances under which a company should consider the use of options. A currency call or put option's value is affected by both direction and volatility changes, and the price of such an option will be higher, the more the market's expectations (as reflected in the forward rate) favor exercise and the greater the anticipated volatility. For example, during the recent crisis in some European countries put options on the Icelandic Krone became very expensive for two reasons. First, high Icelandic interest rates designed to support the Krone drove the forward rate to a discount against the Euro. Second, anticipated volatility of the Euro/ISK exchange rate jumped as dealers speculated on a possible depreciation of the currency. With movements much greater than in the past, the expected gain from exercising puts became much greater. It was an appropriate time for companies with Icelandic exposure to buy puts, but the cost would exceed the expected gain unless the corporate treasurer anticipated a greater change, or an even higher volatility, than those reflected in the market price of options. Finally, one can justify the limited use of options by reference to the deleterious effect of financial distress. Unmanaged exchange rate risk can cause significant fluctuations in the earnings and the market value of an international firm. A very large exchange rate movement may cause special problems for a particular company, perhaps because it brings a competitive threat from a different country. At some level, the currency change may threaten the firm's viability, bringing the costs of bankruptcy to bear. To avert this, it may be worth buying some low-cost options that would pay off only under unusual circumstances, ones that would particularly hurt the firm. Out-of-the-money options may be a useful and cost-effective way to hedge against currency risks that have very low probabilities but which, if they occur, have disproportionately high costs to the company.

CONCLUSION: Many corporate risk managers attempt to construct hedges on the basis of their outlook for interest rates, exchange rates or some other market factor. However, the best hedging decisions are made when risk managers acknowledge that market movements are
89

unpredictable. A hedge should always seek to minimize risk. It should not represent a gamble on the direction of market prices. A well-designed hedging program reduces both risks and costs. Hedging frees up resources and allows management to focus on the aspects of the business in which it has a competitive advantage by minimizing the risks that are not central to the basic business. Ultimately, hedging increases shareholder value by reducing the cost of capital and stabilizing earnings.

HEDGING FOREIGN EXCHANGE RISK WITH FORWARDS, FUTURES, OPTIONS AND THE GOLD DINAR: A COMPARISON NOTE
THE 1997 EAST ASIAN economic crisis made apparent how vulnerable currencies can be. The speculative attacks on the ringgit for example, almost devastated the economy if not for the quick and bold counter actions taken by the Malaysian government, particularly in checking the offshore ringgit transactions. It also made apparent the need for firms to manage foreign exchange risk. Many individuals, firms and businesses found themselves helpless in the wake of drastic exchange rate movements. Malaysia being among the most open countries in the world, in terms of international trade, was exposed to significant foreign exchange risk. Foreign exchange risk refers to the uncertainties faced due to fluctuating exchange rates. For example, a Malaysian trader who exports palm oil to India for future payments to be received in rupees, faces the risk of rupees depreciating against the ringgit at the time the payment is made. This is because if the rupee depreciates, a smaller amount of ringgit will be received when the rupees are exchanged into ringgit. Therefore, what originally seemed a profitable venture could turn out to be a loss due to exchange rate fluctuations. Such risks are common in international trade and finance. A significant number of international investments, trades and dealings are shelved due to the unwillingness of parties concerned to bear foreign exchange risk. Hence it is important for businesses to manage this foreign exchange risk so that they may concentrate on what they are good at and eliminate or minimize a risk that is not their trade. Unfortunately, however, in the case of most developing nations including Malaysia, tools available for managing foreign exchange risk are minimal. Traditionally, the forward rates, currency futures and options have been used for this purpose. The futures and options markets are also known as derivative markets. However, in many nations, including Malaysia, futures and options on currencies are not available. The Malaysian Derivatives Exchange (MDEX), for example, makes available a number of derivative instruments Kuala Lumpur Composite Index Futures, Index Options, Crude Palm Oil Futures and KLIBOR (interest rate) Futures but not ringgit futures or options. Even in countries where currency derivative markets exist, however, for example the Philadelphia Stock Exchange in the United States, not all derivatives on all currencies are traded. Derivatives are available only on select major world currencies. While the existence
90

of these markets assists in risk management, speculation and arbitrage also thrive in them. This section compares and contrasts the use of derivatives forwards, futures and options and the gold dinar for hedging foreign exchange risk. It also argues why a gold dinar system is likely to introduce efficiency into the market while reducing the cost of hedging against foreign exchange risk, compared with the derivatives.

HEDGING WITH FORWARDS Hedging refers to managing risk to an extent that it is bearable. In international trade and dealings foreign exchange plays an important role. Fluctuations in foreign exchange rates can have significant implications on business decisions and outcomes. Many international trade and business dealings are shelved or become unworthy due to significant exchange rate risk embedded in them. Historically, the foremost instrument used for managing exchange rate risk is the forward rate. Forward rates are custom agreements between two parties to fix the exchange rate for a future transaction. This simple arrangement easily eliminates exchange rate risk, however, it has some shortcomings, particularly the difficulty in getting a counter party who would agree to fix the future rate for the amount and at the time period in question. In Malaysia many businesses are not even aware that some banks do provide forward rate arrangements as a service to their customers. By entering into a forward rate agreement with a bank, the businessman simply transfers the risk to the bank, which will now have to bear this risk. Of course, the bank, in turn, may have to make some other arrangement to manage this risk. Forward contracts are somewhat less familiar, probably because no formal trading facility, building or even regulating body exists.

An Example of Hedging Using Forward Agreement Assume that a Malaysian construction company, ABC Corporation just won a bid to build a stretch of road in India. Now is July and the contract signed for 10,000,000 rupees, would be paid for in September. This amount is consistent with ABCs minimum revenue of RM1,000,000 at the exchange rate of RM0.10 per rupee. Nonetheless, fluctuating exchange rates could end with a possible depreciation of rupees and thus render the project unworthy. ABC, therefore, enters into a forward contract with the First Bank of India to fix the exchange rate at RM0.10 per rupee. The forward contract is a legal agreement and, therefore, constitutes obligations on both sides. The First Bank may have to find a counter party for this transaction either a party that wants to hedge against an appreciation of 10,000,000 rupees expiring at the same time or a party that wishes to speculate on an upward trend in rupees. If the bank itself plays the counter party, then the risk would be borne by the bank. The existence of speculators increases the probability of finding a counter party. By entering into a forward contract ABC is guaranteed of an exchange rate of RM0.10 per rupee in the future,
91

irrespective of what happens to the spot rupee exchange rate. If the rupee were to actually depreciate, ABC would then be protected. However, if it were to appreciate, then ABC would have to forego this favorable movement and hence bear some implied losses. Even though a favorable movement could be lost, ABC still proceeds with the hedging since it knows that a guaranteed exchange rate of RM0.10 per rupee is consistent with a profitable venture.

HEDGING WITH FUTURES The futures market came into existence as an answer for the shortcomings inherent in the forward market. The futures market solves some of the shortcomings of the forward market, particularly the need and the difficulty in finding a counter party. A currency futures contract is an agreement between two parties to buy or sell a particular currency at a future date, at a particular exchange rate that is fixed or agreed upon upfront. This sounds a lot like the forward contract. In fact, the futures contract is similar to the forward contract but is much more liquid. It is liquid because it is traded in an organized exchange i.e. the futures market. Futures contracts are standardized contracts and thus are bought and sold just like shares in a stock market. The futures contract is also a legal contract just like the forward, however, the obligation can be removed prior to the expiry of the contract by making an opposite transacti on, i.e. if one had purchased a futures contract then one may exit by selling the same contract. When hedging with futures, if the risk is an appreciation in value, then one needs to buy futures, whereas if the risk is a depreciation then one needs to sell futures. Consider our earlier example, instead of using forwards, ABC could have thus sold rupee futures to hedge against a rupee depreciation. Lets assume accordingly that ABC sold rupee futures at the rate RM0.10 per rupee. Hence the size of the contract is RM1,000,000. Now assume that the rupee depreciates to RM0.07 per rupee the very thing ABC was afraid of (See Table 4). ABC would then close the futures contract by buying back the contract at this new rate. Note that in essence ABC bought the contract for RM0.07 and sold it for RM0.10. This gives a futures profit of RM300,000 [(RM0.10-RM0.07) x 10,000,000]. However, in the spot market ABC gets only RM700,000 when it exchanges the 10,000,000 rupees at RM0.07. The total cash flow, however, is maintained at RM1,000,000 (RM700,000 from spot and RM300,000 profit from futures). With perfect hedging the cash flow would always be RM1 million no matter what happens to the exchange rate in the spot market. One advantage of using futures for hedging is that ABC can release itself from the futures obligation by buying back the contract any time before the expiry of the contract. To enter into a futures contract a trader, however, needs to pay a deposit (called an initial margin) first. Then his position will be tracked on a daily basis so much so that whenever his account makes a loss for the day, the trader will receive a margin call (also known as variation margin), requiring him to pay up the losses.

92

STANDARDIZED FEATURES OF THE FUTURES CONTRACT AND LIQUIDITY Unlike the forward contract, the futures contract has a number of features that have been standardized. These standard features increase the liquidity in the market, i.e. increase the number of transactions that match in terms of size and expiration. In the practical world, traders are faced with diverse conditions that need diverse actions (like the need to hedge different amounts of currency at different points of time in the future) such that matching transactions can be difficult. By standardizing the contract sizes (i.e. the amount) and the expiry dates, these different needs can be matched to some degree, even though not perfectly perhaps. Some of the standardized features include the expiry date, contract month, contract size, position limits (i.e. the number of contracts a party can buy or sell) and price limit (i.e. the maximum daily price movements allowed). Nevertheless, these standardized features introduce some hedging imperfections. In our earlier example, assuming the size of each rupee futures contract to be 2,000,000, then 5 contracts need to be sold for a contract size of 10,000,000 rupees. However, if the size of each contract is 3,000,000 for instance, then only 3 contracts can be sold, leaving 1,000,000 rupees un-hedged. Therefore, with standardization, some part of the spot position can go unhedged. Some advantages and disadvantages of hedging using futures are summarized below:

93

ADVANTAGES OF THE FUTURES CONTRACT

Liquid and central market: Since futures contracts are traded on a central market, this increases liquidity. There are many market participants and hence one may easily buy or sell futures contracts. The problem of double coincidence of wants that could exist in the forward market is greatly reduced. A trader who has taken a position in the futures market can easily make an opposite transaction and thereby close his or her position. However, such easy exit is not a feature of the forward market.

Leverage: Leverage is brought about by the futures markets margin system, where a trader takes on a larger position with only a small initial deposit. If the futures contract with a value of RM1,000,000 requires an initial margin of only RM100,000, then a one per cent change in the futures price (i.e. RM10,000) would bring about a 10 per cent change relative to the traders initial outlay. This amplification of profits (or losses) is called leverage. Leverage allows the trader to hedge much bigger amounts with smaller outlays.

Positions can be easily closed out: As mentioned earlier, positions taken in the futures market can be easily closed out by making opposite transactions. If a trader had sold 5 rupee futures contracts expiring in December, then the trader could close that position by buying 5 December rupee futures. In hedging, such closing-out of positions is done close to the expected physical spot transactions. Profits or losses from futures would offset the opposite losses or profits from the spot transaction. Nevertheless, such offsetting may not be perfect due to the imperfections brought about by the standardized features of the futures contract.

Convergence: As the futures contract approaches expiration, its price and the spot price would tend to converge. On the day of expiration both prices should be equal. Convergence is brought about by the activities of arbitrageurs who would move in to profit if price disparities were to exist between the futures and the spot, i.e. buying in the cheaper market and selling in the higher priced one.

DISADVANTAGES OF THE FUTURES CONTRACT

94

Legal obligation: The futures contract, just like the forward contract, is a legal obligation. Being a legal obligation it can sometimes pose problems. For example, if futures are used for hedging a project that is still in the bidding process, the futures position can turn into a speculative position in the event the bidding turns out unsuccessful.

Standardized features: Since the futures contract has some of its features standardized like the contract size, expiry date, etc., perfect hedging may be impossible. Since over-hedging is also not advisable, some part of the spot transactions will, therefore, have to go unhedged.

Initial and daily variation margins: This is a unique feature of the futures contract. A trader who wishes to take a position in the futures market must first pay an initial margin or deposit. This deposit will be returned when the trader closes his or her position. Also, the futures contract is marked to market, i.e. its position is tracked on a daily basis and the trader would be required to pay up variation margins in the event of daily losses. The initial and daily variation margins can pose a significant cash flow burden on traders or hedgers.

Forego favourable movements: In hedging using futures, any losses or profits in the spot transaction would be offset by profits or losses from the futures transaction. Consider our earlier example where ABC sold rupee futures to protect against a rupee depreciation. However, if the rupee were to appreciate, then ABC would have to forego such favourable movements.

The above shortcomings of the futures contract, particularly it being a legal obligation, with margin requirements and the need to forego favourable movements, prompted the development and establishment of the options markets that deal in more flexible instruments, i.e. the options contracts.

HEDGING USING OPTIONS

95

A currency option may be defined as a contract between two parties a buyer and a seller whereby the buyer of the option has the right but not the obligation, to buy or sell a specified currency at a specified exchange rate, at or before a specified date, from the seller of the option. While the buyer of an option enjoys a right but not an obligation, the seller of the option, nevertheless, has an obligation in the event the buyer exercises the given right. There are two types of options:

Call option gives the buyer the right to buy a specified currency at a specified exchange rate, at or before a specified date. Put option gives the buyer the right to sell a specified currency at a specified exchange rate, at or before a specified date.

The seller of the option, of course, needs to be compensated for giving the right. The compensation is called the price or the premium of the option. The seller thus has an obligation in the event the right is exercised by the buyer. For example, assume that a trader buys a September RM0.10 rupee call option for RM0.01. This means that the trader has the right to buy rupees for RM0.10 per rupee at any time until the contract expires in September. The trader pays a premium of RM0.01 for this right. The RM0.10 is called the strike price or the exercise price. If the rupee appreciates over RM0.10 any time before expiry, the trader may exercise his right and buy it for only RM0.10 per rupee. If, however, the rupee were to depreciate below RM0.10, the trader may just let the contract expire without taking any action since he is not obligated to buy it at RM0.10. In this case, if he needs physical rupee, he may just buy it in the spot market at the new lower rate. In hedging using options, calls are used if the risk is an upward trend in price, while puts are used if the risk is a downward trend. In our ABC example, since the risk is a depreciation of rupees, ABC would need to buy put options on rupees. If rupees were to depreciate at the time ABC receives its rupee revenue, then ABC would exercise its right and thereby effectively obtain a higher exchange rate. If, however, rupees were to appreciate instead, ABC would then just let the contract expire and exchange its rupees in the spot market at the higher exchange rate. Therefore, the options market allows traders to enjoy unlimited favourable movements while limiting losses. This feature is unique to options, unlike the forward or futures contracts where the trader has to forego favourable movements and there are also no limits to losses. Options are particularly suited as a hedging tool for contingent cash flows, as is the case in bidding processes. When a firm bids for a project overseas, which involves foreign exchange risk, the options market allows it to quote its bid price and at the same time protect itself from the exchange rate fluctuations in the event the bid is won. In the case of hedging with forwards or futures, the firm would be automatically placed in a speculative position in the event of an unsuccessful bid, without any limit to its downside losses. An Example of Hedging with Put Options
96

Consider our ABC Corp. example. Instead of already having won the contract in question, lets, however, assume that it is in the process of bidding for it as is the common case in real life. ABC wants a minimum acceptable revenue of RM1,000,000 after hedging costs, but ABC need to quote a bid price now. In this instance, ABC would face the exchange rate risk only upon winning the bid. Options fare better as a hedging tool here compared with forwards or futures due to the uncertainty in getting the contract. Assume that it is now July and the results of the bidding will be known only in September, and that the following September options quotes are available today: RM0.10 call @ RM0.002 RM0.10 put @ RM0.001 Assume that the size of each rupee contract is 2,000,000 rupees. The following is how ABC could make its hedging strategy: 1. First, it needs to decide whether to buy puts or calls. Since ABC would receive rupees in the future if it won the contract, its risk is a depreciation of rupees. Therefore, it should buy puts. 2. What should the bid amount be? To answer this question we need to compute the effective exchange rate after incorporating the price of put, i.e. RM0.10 minus RM0.001 which equals RM0.099. Now the bid amount is computed as RM1,000,000/RM0.099, which equals 10,101,010 rupees. 3. How many put contracts should it buy? To answer this, just take the bid amount and divide by the contract size, i.e. 10,101,010/2,000,000 equals 5.05. Since fractions of contracts are not allowed and we dont over-hedge, 5 contracts are sufficient, with some portion going unhedged. However, if we want to guarantee a minimum revenue of RM1,000,000, we cannot tolerate any imperfections in the hedging. Therefore, in this example we should go for 6 contracts. 4. What is the cost of hedging? The cost of hedging is computed as follows: 6 contracts x 2,000,000 per contract x RM0.001 equals RM12,000. This cost of hedging is the maximum loss possible with options. In September, ABC would have known the outcome of the bid and by then the spot rupee rate might have appreciated or depreciated. Lets look at two scenarios where the rupee appreciates to RM0.20 in one and depreciates to RM0.05 per rupee in the other. Table 5 shows the four outcomes possible and their cash flow implications.

97

The above example illustrates how options can be used to guarantee a minimum cash flow on contingent claims. In the case the bid is won, a minimum cash flow of RM1,000,000 is guaranteed while allowing one to still enjoy a favourable movement if that does take place. If the bid is lost, the maximum loss possible is the premium paid. An example for hedging with the call option is when a firm bids to buy a property (e.g. land) in another country. Say, a company bids to buy a piece of land in Indonesia to plant oil palm trees. Assume that the bidding is in Indonesian rupiahs. Here the risk would be an appreciation of the rupiah. Therefore, buying call options on the rupiah would be the suitable hedging strategy. If one analyzes it carefully, the options market is simply an organized insurance market. One pays a premium to protect oneself from potential losses while allowing one to enjoy potential benefits. An analogy, for example, is when one buys car insurance, by paying the premium. If the car gets into an accident one gets compensated by the insurance company for the losses incurred. However, if no accident happens, one loses the premium paid. If no accident happens but the value of the car appreciates in the secondhand market, then one gets to enjoy the upward trend in price. An options market plays a similar role. In the case of options, however, the seller of an option plays the role akin to an insurance company.

98

ADVANTAGES AND DISADVANTAGES OF HEDGING USING OPTIONS

The advantages of options over forwards and futures are basically the limited downside risk and the flexibility and variety of strategies made possible. Also in options there is neither the initial margin nor the daily variation margin since the position is not marked to market. This relieves traders from potential cash flow problems. Options are, however, more expensive because they are much more flexible compared to forwards or futures. The option price is, therefore, probably its disadvantage. THE GOLD DINAR Some readers by now would have realized that the examples of rupee and rupiah futures and options are hypothetical. There are no such derivatives traded on any organized exchange. But that is precisely the point we intend to highlight. Currently, derivatives are mostly traded only in select major world currencies like the yen, pound sterling, Australian dollar, etc. against the US dollar. For most other currencies of the world including almost all of the developing nations there are no formal tools to hedge against foreign exchange risk. Malaysia, Thailand, Indonesia, the Philippines, India, etc. are no exception to this. The use of the gold dinar to settle their bilateral and multilateral trade is expected to introduce some stability into the foreign exchange problem. In this mode, gold is used as a medium of exchange instead of the national currencies. The prices of exports and imports are quoted in weights of gold. If countries use the gold payment system, then the problem of foreign exchange risk can be significantly minimized or eliminated.

HEDGING USING THE GOLD DINAR In the gold dinar mode, the central bank would play the important role of keeping national trade accounts and providing a safe place to keep the gold. The gold accounting is kept through the medium of the central banks and only the net difference between the countries is settled periodically, say, in a gold custodians account. However, since international trade is an ongoing continuous process, any gold that needs to be settled can always be brought forward and used for future transactions and settlements. As an example, consider that Malaysia exports 10 million gold dinar worth of goods and services to Indonesia while importing 8 million worth of goods and services. Hence Malaysia has a surplus trade of 2 million gold dinar. Indonesia needs to settle only this difference of 2 million.
99

However, this amount could be used for settling future trade imbalances between the countries and hence a physical gold movement between the countries is not necessary. This simple structure completely eliminates exchange rate risk if all pricings are done in gold dinar. Even though the international gold price may fluctuate, the participants realize that they are dealing in something that has intrinsic value, that can be used for stable and continuous trade into the future. Therefore, even though with the existence of other national currencies, speculation and arbitrage on gold price could tempt a participating country to redeem or sell its gold, it should resist such temptation for the sake of the stability of future trade.

This simple gold payment system has numerous advantages: 1. Foreign exchange risk would be totally eliminated if a comprehensive gold dinar model is implemented. This means there is no need for forwards, futures or options on the currencies of the participating countries. 2. Reduced currency speculation and arbitrage between the currencies. For example, if three countries agree to use the gold payment system, then it is akin to the three currencies becoming a single currency. Speculation and arbitrage among these three currencies will be very much reduced. This unification of the three currencies through the gold dinar provides benefits of diversification. It is like obtaining diversification through a portfolio of stocks. Individual currencies face risks that are unique to the issuing country, but in a unified currency such unique risks would be diversified away. In fact, since gold is treasured by all people, it is a suitable global currency that enjoys global diversification, i.e. no single countrys unique risk may be significantly embedded in gold. 3. Low transaction costs since only accounting records need to be kept. Transactions can be executed by means of the electronic medium with minimal charges. 4. Greatly reduces the possibility of future speculative attacks on national currencies.

The cost and benefits of using forwards, futures, options and the gold dinar for hedging foreign exchange risk are compared and summarized in Table 6. In the final analysis, the gold dinar is akin to the forward contract, but with its problems of barter, speculation and arbitrage removed; and is a superior tool for foreign exchange risk management compared to the futures and options contracts.

100

The Economist magazines Pocket World in Figures (2002 edition) ranks Malaysia the second most trade dependent country in the world. Trade as a percentage of GDP is 92 per

101

cent for Malaysia, even higher than that of Singapore which ranks third with a percentage of 78.8 per cent. With the coexistence of national currencies though, some price risk may still exist. Nevertheless, gold has its own intrinsic value and thereby has held its value stable historically.

HEDGE AGAINST EXCHANGE RATE RISK WITH CURRENCY ETFS :

Investments in overseas instruments, such as stocks and bonds, can generate substantial returns and provide a greater degree of portfolio diversification, but they introduce an added risk, that of exchange rates. Since foreign exchange rates can have a significant impact on portfolio returns, investors should consider hedging this risk where appropriate. While hedging instruments such as currency futures, forwards and options have always been available, their relative complexity has hindered widespread adoption by the average investor. On the other hand, currency ETFs, by virtue of their simplicity, flexibility and liquidity, are ideal hedging instruments for retail investors who wish to mitigate exchange rate risk. IMPACT OF EXCHANGE RATES ON CURRENCY RETURNS The first decade of the new millennium proved to be a very challenging one for investors. U.S. investors who chose to restrict their portfolios to large-cap U.S. stocks saw the value of their holdings decline by an average of more than one-third. Over the approximately nineand-a-half-year period from January 2000 to May 2009, the S&P 500 index fell by about 40%. Including dividends, the total return from the S&P 500 over this period was approximately -26% or an average of -3.2% annually. Equity markets in Canada, the largest trading partner of the U.S., fared much better during this period. Fueled by surging commodity prices and a buoyant economy, Canada's S&P/TSX Composite index rose about 23%; including dividends, the total return was 49.7%, or 4.4% annually. This means that the Canadian S&P/TSX Composite index outperformed the S&P 500 by 75.7% cumulatively or about 7.5% annually. U.S. investors who were invested in the Canadian market over this period did much better than their stay-at-home compatriots, as the Canadian dollar's 33% appreciation versus the greenback turbocharged returns for U.S. investors. In U.S. dollar terms, the S&P/TSX
102

Composite gained 63.2%, and provided total returns, including dividends of 98.3% or 7.5% annually. That represents an outperformance versus the S&P 500 of 124.3% cumulatively or 10.7% annually. This means that $10,000 invested by a U.S. investor in the S&P 500 in January 2000 would have shrunk to $7,400 by May 2009, but $10,000 invested by a U.S. investor in the S&P/TSX Composite over the same period would have almost doubled, to $19,830. WHEN TO CONSIDER HEDGING:

U.S. investors who were invested in overseas markets and assets during the first decade of the 21st century reaped the benefits of a weaker U.S. dollar, which was in long-term or secular decline for much of this period. Hedging exchange risk was not advantageous in these circumstances, since these U.S. investors were holding assets in an appreciating (foreign) currency. However, a weakening currency can drag down positive returns or exacerbate negative returns in an investment portfolio. For example, Canadian investors who were invested in the S&P 500 from January 2000 to May 2009 had returns of -44.1% in Canadian dollar terms (compared with returns for -26% for the S&P 500 in U.S. dollar terms), because they were holding assets in a depreciating currency (the U.S. dollar, in this case). As another example, consider the performance of the S&P/TSX Composite during the second half of 2008. The index fell 38% during this period - one of the worst performances of equity markets worldwide - amid plunging commodity prices and a global sell off in all asset classes. The Canadian dollar fell almost 20% versus the U.S. dollar over this period. A U.S. investor who was invested in the Canadian market during this period would therefore have had total returns - excluding dividends for the sake of simplicity - of -58% over this sixmonth period. Penny Stock of the Day In this case, an investor who wanted to be invested in Canadian equities while minimizing exchange risk could have done so using currency ETFs. The following section demonstrates this concept.

HEDGING USING CURRENCY ETFS: Consider a U.S. investor who invested $10,000 in the Canadian equity market through the I Shares MSCI Canada Index Fund (EWC). This ETF seeks to provide investment results that correspond to the price and yield performance of the Canadian equity market, as measured by
103

the MSCI Canada index. The ETF shares were priced at $33.16 at the end of June 2008, so an investor with $10,000 to invest would have acquired 301.5 shares (excluding brokerage fees and commissions). If this investor wanted to hedge exchange risk, he or she would also have sold short shares of the Currency Shares Canadian Dollar Trust (FXC). This ETF reflects the price in U.S. dollars of the Canadian dollar. In other words, if the Canadian dollar strengthens versus the U.S. dollar, the FXC shares rise, and if the Canadian dollar weakens, the FXC shares fall.

Recall that if this investor had the view that the Canadian dollar would appreciate, he or she would either refrain from hedging the exchange risk, or "double up" on the Canadian dollar exposure by buying (or "going long") FXC shares. However, since our scenario assumed that the investor wished to hedge exchange risk, the appropriate course of action would have been to "short sell" the FXC units. In this example, with the Canadian dollar trading close to parity with the U.S. dollar at the time, assume that the FXC units were sold short at $100. Therefore, to hedge the $10,000 position in the EWC units, the investor would short sell 100 FXC shares, with a view to buying them back at a cheaper price later if the FXC shares fell. At the end of 2008, the EWC shares had fallen to $17.43, a decline of 47.4% from the purchase price. Part of this decline in the share price could be attributed to the drop in the Canadian dollar versus the U.S. dollar over this period. The investor who had a hedge in place would have offset part of this loss through a gain in the short FXC position. The FXC shares had fallen to about $82 by the end of 2008, so the gain on the short position would have amounted to $1,800. The unhedged investor would have had a loss of $4,743 on the initial $10,000 investment in the EWC shares. The hedged investor, on the other hand, would have had an overall loss of $2,943 on the portfolio.

CURRENCY ETFS ARE MARGIN-ELIGIBLE: Some investors may believe that it is not worthwhile to invest a dollar in a currency ETF to hedge each dollar of an overseas investment. However, since currency ETFs are margineligible, this hurdle can be overcome by using margin accounts (which are brokerage accounts in which the brokerage lends the client part of the funds for an investment) for both the overseas investment and currency ETF.
104

An investor with a fixed amount to invest who also wishes to hedge exchange risk can make the investment with 50% margin and use the balance of 50% for a position in the currency ETF. Note that making investments on margin amounts to using leverage, and investors should ensure that they are familiar with the risks involved in using leveraged investment strategies.

THE BOTTOM LINE:

Currency moves are unpredictable and currency gyrations can have an adverse effect on portfolio returns. As an example, the U.S. dollar unexpectedly strengthened against most major currencies during the first quarter of 2009, amid the worst credit crisis in decades. These currency moves amplified negative returns on overseas assets for U.S. investors during this period. Hedging exchange risk is a strategy that should be considered during periods of unusual currency volatility. Because of their investor-friendly features, currency ETFs are ideal hedging instruments for retail investors to hedge exchange risk. HOW COMPANIES USE DERIVATIVES TO HEDGE RISK ?

If you are considering a stock investment and you read that the company uses derivatives to hedge some risk, should you be concerned or reassured? Warren Buffett's stand is famous: he has attacked all derivatives, saying he and his company "view them as time bombs, both for the parties that deal in them and the economic system" (2003 Berkshire Hathaway Annual Report). On the other hand, the trading volume of derivatives has escalated rapidly, and nonfinancial companies continue to purchase and trade them in ever-greater numbers. To help you evaluate a company's use of derivatives for hedging risk, we'll look at the three most common ways to use derivatives for hedging.

105

FOREIGN-EXCHANGE RISKS :
One of the more common corporate uses of derivatives is for hedging foreign-currency risk, or foreign-exchange risk, which is the risk that a change in currency exchange rates will adversely impact business results. Let's consider an example of foreign-currency risk with ACME Corporation, a hypothetical U.S.-based company that sells widgets in Germany. During the year, ACME Corp sells 100 widgets, each priced at 10 euros. Therefore, our constant assumption is that ACME sells 1,000 euros worth of widgets:

When the dollar-per-euro exchange rate increases from $1.33 to $1.50 to $1.75, it takes more dollars to buy one euro, or one euro translates into more dollars, meaning the dollar is depreciating or weakening. As the dollar depreciates, the same number of widgets sold translates into greater sales in dollar terms. This demonstrates how a weakening dollar is not all bad: it can boost export sales of U.S. companies. (Alternatively, ACME could reduce its prices abroad, which, because of the depreciating dollar, would not hurt dollar sales; this is another approach available to a U.S. exporter when the dollar is depreciating.) The above example illustrates the "good news" event that can occur when the dollar depreciates, but a "bad news" event happens if the dollar appreciates and export sales end up being less. In the above example, we made a couple of very important simplifying assumptions that affect whether the dollar depreciation is a good or bad event: (1) We assumed that ACME Corp. manufactures its product in the U.S. and therefore incurs its inventory or production costs in dollars. If instead ACME manufactured its German
106

widgets in Germany, production costs would be incurred in euros. So even if dollar sales increase due to depreciation in the dollar, production costs will go up too! This effect on both sales and costs is called a natural hedge: the economics of the business provide their own hedge mechanism. In such a case, the higher export sales (resulting when the euro is translated into dollars) are likely to be mitigated by higher production costs. (2) We also assumed that all other things are equal, and often they are not. For example, we ignored any secondary effects of inflation and whether ACME can adjust its prices. Penny Stock of the Day Even after natural hedges and secondary effects, most multinational corporations are exposed to some form of foreign-currency risk. Now let's illustrate a simple hedge that a company like ACME might use. To minimize the effects of any USD/EUR exchange rates, ACME purchases 800 foreign-exchange futures contracts against the USD/EUR exchange rate. The value of the futures contracts will not, in practice, correspond exactly on a 1:1 basis with a change in the current exchange rate (that is, the futures rate won't change exactly with the spot rate), but we will assume it does anyway. Each futures contract has a value equal to the "gain" above the $1.33 USD/EUR rate. (Only because ACME took this side of the futures position, somebody - the counter-party - will take the opposite position):

In this example, the futures contract is a separate transaction; but it is designed to have an inverse relationship with the currency exchange impact, so it is a decent hedge. Of course, it's not a free lunch: if the dollar were to weaken instead, then the increased export sales are mitigated (partially offset) by losses on the futures contracts. HEDGING INTEREST-RATE RISK :

107

Companies can hedge interest-rate risk in various ways. Consider a company that expects to sell a division in one year and at that time to receive a cash windfall that it wants to "park" in a good risk-free investment. If the company strongly believes that interest rates will drop between now and then, it could purchase (or 'take a long position on') a Treasury futures contract. The company is effectively locking in the future interest rate. Here is a different example of a perfect interest-rate hedge used by Johnson Controls (NYSE:JCI), as noted in its 2004 annual report: Fair Value Hedges - The Company [JCI] had two interest rate swaps outstanding at September 30, 2004, designated as a hedge of the fair value of a portion of fixed-rate bondsThe change in fair value of the swaps exactly offsets the change in fair value of the hedged debt, with no net impact on earnings. (JCI 10K, 11/30/04 Notes to Financial Statements)

Johnson Controls is using an interest rate swap. Before it entered into the swap, it was paying a variable interest rate on some of its bonds. (For example, a common arrangement would be to pay LIBOR plus something and to reset the rate every six months). We can illustrate these variable rate payments with a down-bar chart:

Now let's look at the impact of the swap, illustrated below. The swap requires JCI to pay a fixed rate of interest while receiving floating-rate payments. The received floating-rate payments (shown in the upper half of the chart below) are used to pay the pre-existing floating-rate debt.

108

JCI is then left only with the floating-rate debt, and has therefore managed to convert a variable-rate obligation into a fixed-rate obligation with the addition of a derivative. And again, note the annual report implies JCI has a "perfect hedge": The variable-rate coupons that JCI received exactly compensates for the company's variable-rate obligations. COMMODITY OR PRODUCT INPUT HEDGE :

Companies that depend heavily on raw-material inputs or commodities are sensitive, sometimes significantly, to the price change of the inputs. Airlines, for example, consume lots of jet fuel. Historically, most airlines have given a great deal of consideration to hedging against crude-oil price increases - although at the start of 2004 one major airline mistakenly settled (eliminating) all of its crude-oil hedges: a costly decision ahead of the surge in oil prices. Monsanto (NYSE:MON) produces agricultural products, herbicides and biotech-related products. It uses futures contracts to hedge against the price increase of soybean and corn inventory:

109

Changes in Commodity Prices: Monsanto uses futures contracts to protect itself against commodity price increases these contracts hedge the committed or future purchases of, and the carrying value of payables to growers for soybean and corn inventories. A 10 percent decrease in the prices would have a negative effect on the fair value of those futures of $10 million for soybeans and $5 million for corn. We also use natural-gas swaps to manage energy input costs. A 10 percent decrease in price of gas would have a negative effect on the fair value of the swaps of $1 million. (Monsanto 10K, 11/04/04 Notes to Financial Statements)

CONCLUSION: Three of the most popular types of corporate hedging with derivatives are reviewed. There are many other derivative uses, and new types are being invented. For example, companies can hedge their weather risk to compensate them for extra cost of an unexpectedly hot or cold season. The derivatives we have reviewed are not generally speculative for the company. They help to protect the company from unanticipated events: adverse foreign-exchange or interest-rate movements and unexpected increases in input costs. The investor on the other side of the derivative transaction is the speculator. However, in no case are these derivatives free. Even if, for example, the company is surprised with a good-news event like a favorable interest-rate move, the company (because it had to pay for the derivatives) receives less on a net basis than it would have without the hedge.

LITERATURE REVIEW:
Collier and Davis (1985) in their study about the organisation and practice of currency risk management by U.K. multi-national companies. The findings revealed that there is a degree of centralized control of group currency risk management and that formal exposure management policies existed. There was active management of currency transactions risk. The preference was for risk-averse policies, in that automatic policies of closeout were applied. Batten, Metlor and Wan (1992) focused on foreign exchange risk management practice and product usage of large Australia based firms. The results indicated that, of the 72 firms covered by the Study, 70% of the firms traded their foreign exchange exposures, acting as foreign exchange risk bearers, in an attempt to optimize company returns. Transaction exposure emerged as the most relevant exposure. Jesswein et al, (1993) in their study on use of derivatives by U.S. corporations, categorises foreign exchange risk management products under three generations: Forward contracts belonging to the First Generation; Futures, Options, Futures- Options, Warranties and Swaps belonging to the Second Generation; and Range, Compound Options, Synthetic Products and Foreign Exchange Agreements belonging to the Third Generation.
110

The findings of the Study showed that the use of the third generation products was generally less than that of the second-generation products, which was, in turn, less than the use of the first generation products. The use of these risk management products was generally not significantly related to the size of the company, but was significantly related to the companys degree of international involvement. Phillips (1995) in his study focused on derivative securities and derivative contracts found that organisations of all sizes faced financial risk exposures, indicating a valuable opportunity for using risk management tools. The treasury professionals exhibited selectivity in their use of derivatives for risk management. Howton and Perfect (1998) in their study examines the pattern of use of derivatives by a large number of U.S. firms and indicated that 60% of firms used some type of derivatives contract and only 36% of the randomly selected firms used derivatives. In both samples, over 90% of the interest rate contracts were swaps, while futures and forward contracts comprised over 80% of currency contracts. Hentschel and Kothari (2000) identify firms that use derivatives. They compare the risk exposure of derivative users to that of nonusers. They find economically small differences in equity return volatility between derivative users and nonusers. They also find that currency hedging has little effect on the currency exposure of firms' equity, even though derivatives use ranges from 0.6% to 64.2% of the firm's assets. Our findings are very important since no previous work has examined the FERM practice in Indian context. This study will be a pioneering attempt in Indian scenario and first of its kind to survey the Indian companies and their risk management practices.

OBJECTIVES OF THE STUDY:

Main objectives of the study are: 1. To ascertain the FERM practices, and product usage, of Indian non-financial corporate enterprises. 2. To know the attitudes, perceptions and concerns of Indian firms towards FERM. 3. To understand the level of awareness of derivatives and their uses, among the firms. 4. To ascertain the organization structure, policymaking and control process adopted by the firms, which use derivatives, in managing foreign exchange exposure.

111

SIGNIFICANCE OF THE STUDY: India had earlier followed a tightly regulated foreign exchange regime. The liberalisation of the Indian economy started in 1991. The 1992-93 Budget provided for partial convertibility of Indian Rupee in current accounts and, in March 1993, the Rupee was made fully convertible in current account. Demand and supply conditions now govern the exchange rates in our foreign exchange market. A fast developing economy has to cope with a multitude of changes, ranging from individual and institutional preferences to changes in technology, in economic policies, in regulations etc. Besides, there are changes arising from external trade and capital account interactions. These generate a variety of risks, which have to be managed. There has been a sharp increase in foreign investment in India. Multi-national and transnational corporations are playing increasingly important roles in Indian business. Indian corporate units are also engaging in a much wider range of cross border transactions with different countries and products. Indian firms have also been more active in raising financial resources abroad. All these developments combine to give a boost to cross-currency cash flows, involving different currencies and different countries. The corporate enterprises in India are increasingly alive to the need for organised fund management and for the application of innovative hedging techniques for protecting themselves against attendant risks. Derivatives are the tools that facilitate trading in risk. The foreign exchange market is still evolving and corporate enterprises are going through the movements in transition from a passive to an active role in risk management. There is no organized information available on how the corporate enterprises in India are facing this challenge. It is in this context that a review of the perceptions and concerns of the corporates, in relation to derivatives and of their initiatives in tuning the organisational set up to acquire and adopt the requisite skills in risk management, assumes significance. Appropriate policy and other measures can then be taken to accelerate the process of further development of foreign exchange market and also upgrade foreign exchange risk management (FERM) with higher professionalism and increased effectiveness.

112

CURRENCY RISK MANAGEMENT TECHNIQUES: A firm may choose any one or any set of combinations of the following techniques to manage foreign exchange rate risks.

Matching:Cash inflows in one of the pairing currencies can be offset against cash flows in the others. A firm can balance its receivables and payables in the same currency. Firms may also deliberately influence the balance by arranging short or long term loans or deposits. Multi-lateral Netting:The netting can be done between inflows and outflows of different currencies arising from cross-border transactions of the different entities in the group. This, of course, requires a comprehensive information system concerning foreign exchange dealings of the group companies. Leads and Lags:Within the boundaries of the terms of the trading contracts or in keeping with prevailing commercial practices and within the existing regulations, payments to trading partners or foreign subsidiaries, in currencies whose values are expected to appreciate or depreciate, can be accelerated or delayed. Invoicing and Currency Clauses:Trading companies may, sometimes, have options to invoice their cross-border sales or purchases, in domestic currency, so that the other party absorbs exchange rate risk. Similar choices of invoicing in third country currencies may also be negotiated with trading partners. There are instances of invoicing in terms of currency baskets, comprising a composite index of different national currencies that have been allotted predetermined weights. Judiciously employed, this can help in reducing the impact of volatility of exchange rates.

113

 Forward Currency Transactions:This involves an agreement between two parties, a buyer and a seller, to buy/sell a currency at a later date at a fixed price. Forward currency contracts can be easily arranged with banks, which are ADs in foreign exchange. A forward contract has the advantage of locking in the exchange rate at an agreed level, protecting from adverse movement in exchange rates. Currency Futures:This involves an agreement between two parties, a buyer and a seller, to purchase/sell a currency at a later date at a fixed price, and that it trades on the futures exchange and is subject to a daily settlement procedure to guarantee each party that claims against the other party will be paid. In India, we are yet to have a futures exchange and clearing house for financial futures. Currency Options:Currency options offer the holder the right, but not the obligation, to buy or sell foreign currency at an agreed price, within a specified period of time. Generally, on most exchanges, options are not constructed on the underlying market, but rather convey the right to buy or sell the futures contract. There can be exchange-traded options as also OTC options. Currency Swaps:A financial swap is a transaction in which two parties agree to an exchange of payments over a specified time period. It is ordinarily marked by an exchange of principals, which may be actual or notional. In a cross currency swap, the counter-parties exchange principals in different currencies at an exchange rate that is usually the current spot rate and reverse the exchange at a later date, usually at the same exchange rate. Money Market Hedging:Companies that have need to raise medium term foreign currency loans should explore the possibility of reducing currency risk by raising them in currencies in which they have medium term exposure in terms of receivables and assets in these currencies.

114

INTERNAL FOREIGN EXCHANGE HEDGING TECHNIQUES

The following table makes a brief comparison of some of the internal foreign exchange techniques from the pros and cons aspects relative to others. Table No 7: Comparison of some of the internal foreign exchange techniques from the pros and cons aspects relative to others.

Techniques Borrowing and lending

Description Creates a synthetic forward by borrowing and lending at home and abroad. For example, a long forward foreign-exchange position is equivalent to borrowing at home, converting the proceeds to foreign exchange and investing them abroad. The converse holds for a short forward foreignexchange position. Going short (long) a commodity contract denominated in a foreign currency to hedge a foreign currency to hedge a foreign exchange assets (liability).

Pros Useful when forwards, futures or swaps markets are thin-particularly for long-dated maturates.

Cons Utilises costly managerial resources. May be prohibited by legal restrictions.

Commodity hedging

Commodity markets are usually deep, particularly for maturities up to a year.

Price changes of commodities, in terms of home currency, may not exactly offset price changes in the asset (liability) to be hedged. Appropriate matches may not be available. Utilises costly managerial resources. Appropriate matches may not be available.

Leading and lagging

Equating foreign exchange assets and liabilities by speeding up or slowing down receivables or payables. Equating assets and liabilities denominated in each currency.

Avoids unnecessary hedging costs.

Matching

Avoids unnecessary hedging costs.

Source: Abuaf (1988)

115

If the company organizes its international transactions within the company itself, it is called internal technique. It is also noted that internal techniques use methods of exposure management which are part of a firms regulatory financial management and do not resort to special contractual relationship outside the group of company itself. These techniques aim to reduce or prevent exposed positions from arising. The main forms of internal techniques are netting, matching, pricing policies and asset liability management and leading and lagging.

METHODOLOGY OF THE STUDY:

An exploratory survey, by way of extensive literature review of books, journals and other published data related to the focus of the study, as also concerned websites, was carried out to gather background information about the general nature of the research problem.

1. Sources of Data The required data was collected through the pre-tested questionnaire administered on a judgment sample of 500 corporate enterprises, located in different parts of the country. Information relating to contemporary practices abroad was obtained from published sources such as journals, reports, and from related websites. 2. Sample for the Study A combination of simple random and judgment sampling was used for selecting the corporate enterprises for the exploratory Study. As against the 850 questionnaires circulated, 588 responses were received. 3. Focus of study The Study has its focus on the activity of end users of derivatives and, hence, is confined to nonbanking corporate enterprises. Since banks both use and sell derivatives, they have not been included in the scope of the Study. Risk management practices of Indian subsidiaries of MNCs are determined by their parent companies and, hence, they do not form part of this Study.

116

4. Analysis of data In analyzing the responses, the Microsoft Excel Spreadsheet and the Statistical Package for Social Sciences (SPSS) have been used. Factor Analysis, using Principal Component Method, was done wherever there was need to reduce variables into factors. Correlation analysis was also done, as needed. 5.validity of data Validity of data depends upon the validity of responses given by the respondents.

RESULT ANALYSIS & FINDINGS:

I. PROFILES OF RESPONDENTS The enterprises covered in the sample are from 18 categories of industries. Four sectors including Paints, Print Media, Gems and Jewelry, and Textiles did not respond. Thus, the Study covers responses from 500 enterprises. The sizes of the enterprises, in terms of turnover as well as international involvement (expressed as the sum of values of imports and exports and external commercial borrowings) varied considerably. Maximum number of responses came from the IT category, reflecting the dominance of international transactions in that sector. The foreign transactions were mostly denominated in US dollars, with Euro, Pound Sterling, Japanese Yen, Swiss Franc and Deutsche Mark following in that order. II. USE OF DERIVATIVES Among the 500 respondents, 265 companies (53%) reported using derivatives and the others are not using derivatives. Quite a few returned the questionnaire blank, with the apology that they are not using derivatives. It seems many enterprises are yet to tune in to the need for planned management of exchange risk exposure. Factor Analysis reveals that the main factor responsible for non-use of derivatives is confused perceptions of derivatives use, with its components, concerns about the appropriateness of derivatives in specific situations, risk of the products and general reluctance and fear. Then comes the technical and administrative factor comprising difficulty in pricing and policy constraints, followed by the cost effectiveness factor which questions the utility of derivatives, given the high costs involved. As to the nature of the transactions that are considered for hedging, the responses indicate that hedging is resorted to mostly in respect of transactions involving contractual commitments, rather than foreign repatriations. There also seems to be a preference to restrict the hedging horizon to less than a year. Even among the users of derivatives, the concerns or anxieties about their use arise on them to four factors:

117

 Confused perception, including lack of clarity about investor expectations, difficulties in pricing and valuing, difficulties in evaluating the risk and lack of understanding as to how to monitor and evaluate hedging outcome. Policy and legal issues, covering assessment of credit risk, inadequate support from the Board, tax and legal considerations and disclosure requirements. Monetary considerations, concerned with transaction costs and liquidity problems. Lack of adequate knowledge about the use of derivatives. 65% of the respondents were of the view that enough range of derivative instruments are not available yet. This has the effect of restricting arbitrage opportunities. A good majority felt the need for Rupee-Dollar Options (not in vogue at the time they responded to the questionnaire, but subsequently introduced in July 2003), while others wished that Exchange-Traded Futures were available. From the above, it can be seen that the Indian corporate enterprises are somewhat halting in their approach to the use of derivatives. III. WHY DO COMPANIES HEDGE? Responding to the question as to why companies hedge, the most important reason adduced is to reduce the volatility of the cash flows. Next in importance comes, maximising share holder value and then, reducing volatility of reported accounting earnings.

Corporations in which individual investors place their money have exposure to fluctuations in all kinds of financial prices, as a natural by-product of their operations. Financial prices include foreign exchange rates, interest rates, commodity prices and equity prices. The effect of changes in these prices on reported earnings can be overwhelming. Often, you will hear companies say in their financial statements that their income was reduced by falling commodity prices or that they enjoyed a windfall gain in profit attributable to the decline of the Canadian dollar. This section will give a brief overview of the different ways in which firms approach this financial price risk and it will introduce the rationale for using derivative products. While there has been a great deal of negative attention paid to derivatives in the mainstream press, the opportunities they provide make derivatives a necessary part of the future of any corporation. One reason why companies attempt to hedge these price changes is because they are risks that are peripheral to the central business in which they operate. For example, an investor buys the stock of a pulp-and-paper company in order to gain from its management of a pulp-and-paper business. She does not buy the stock in order to take advantage of a falling Canadian dollar, knowing that the company exports over 75% of its product to overseas markets. This is the insurance argument in favor of hedging. Similarly, companies are expected to take out insurance against their exposure to the effects of theft or fire.
118

By hedging, in the general sense, we can imagine the company entering into a transaction whose sensitivity to movements in financial prices offsets the sensitivity of their core business to such changes. As we shall see in this article and the ones that follow, hedging is not a simple exercise nor is it a concept that is easy to pin down. Hedging objectives vary widely from firm to firm, even though it appears to be a fairly standard problem, on the face of it. And the spectrum of hedging instruments available to the corporate Treasurer is becoming more complex every day. Another reason for hedging the exposure of the firm to its financial price risk is to improve or maintain the competitiveness of the firm. Companies do not exist in isolation. They compete with other domestic companies in their sector and with companies located in other countries that produce similar goods for sale in the global marketplace. Again, a pulp-and-paper company based in Canada has competitors located across the country and in any other country with significant pulp-and-paper industries, such as the Scandinavian countries. Companies that are the most sophisticated in this field recognize that the financial risks that are produced by their businesses present a powerful opportunity to add to their bottom line while prudently positioning the firm so that it is not pejoratively affected by movements in these prices. This level of sophistication depends on the firm's experience, personnel and management approach. It will also depend on their competitors. If there are five companies in a particular sector and three of them engage in a comprehensive financial risk management program, then that places substantial pressure on the more passive companies to become more advanced in risk management or face the possibility of being priced out of some important markets. Firms that have good risk management programs can use this stability to reduce their cost of funding or to lower their prices in markets that are deemed to be strategic and essential to the future progress of their companies. Most importantly, hedging is contingent on the preferences of the firm's shareholders. There are companies whose shareholders refuse to take anything that appears to be financial price risk while there are other companies whose shareholders have a more worldly view of such things. It is easy to imagine two companies operating in the same sector with the same exposure to fluctuations in financial prices that conduct completely different policy, purely by virtue of the differences in their shareholders' attitude towards risk.

119

THE HEDGING PROBLEM The core problem when deciding upon a hedging policy is to strike a balance between uncertainty and the risk of opportunity loss. It is in the establishment of balance that we must consider the risk aversion, the preferences, of the shareholders. Make no mistake about it. Setting hedging policy is a strategic decision, the success or failure of which can make or break a firm. Consider the example of the Canadian pulp-and-paper company from before, 75% of whose product is sold in US dollars to customers located all over the world. The US dollar here is called the price of determination because all sales of pulp-and-paper are denominated in US dollars. They close a deal for US$10 million worth of product and they know that in one month's time they will receive payment into their US dollar accounts. However, they understand that from the inception of the contract which binds them to have receivables in US dollars in one month's time they are exposed to changes in the rate of exchange for the Canadian dollar against the US dollar. Immediately, they are faced with a problem. As a Canadian company, they will have to repatriate those US dollars at some point because they have decided that foreign exchange risk is not something that they are prepared to carry as it is deemed it to be peripheral to their core business. The problem has two dimensions: uncertainty and opportunity. If they do not hedge the transaction in any way, they do not know with any certainty at what rate of exchange they can exchange the US$10 million when it is delivered. It could be at a better rate or at a worse rate than the rate prevailing currently for exchange of that amount in one month's time. Let's call the prevailing spot rate, for argument's sake, 1.5300 and the prevailing one month forward outright rate at which they could hedge themselves 1.5310. If they do enter into a forward contract in which they obligate themselves to buy Canadian dollars and sell US dollars for delivery on the same date as the delivery date on their pulpand-paper contract, they have removed this uncertainty. They know without any question at what rate this exchange will be. It will be 1.5310. But, they have now taken on infinite risk of opportunity loss. If the Canadian dollar weakens because of some unforeseen event and in one month's time the prevailing spot rate turns out to be 1.5600, then they have foregone 290,000 Canadian dollars. This is their opportunity loss.
120

Are there instruments that address both certainty and opportunity loss? Fortunately, there are. They are called derivatives or derivative products. Most financial institutions make markets in a panoply of risk management solutions involving derivative products. Some of them come as stand-alone solutions and others are presented as packages or combinations. A derivative product is a financial instrument whose price depends indirectly on the behaviour of a financial price. For example, the price of a foreign exchange option on the Canadian dollar in which our company had the right but not the obligation to buy Canadian dollars and sell US dollars at a pre-set strike price will vary on a day-to-day basis with the movement in the Canadian dollar/US dollar exchange rate. If the Canadian dollar gets stronger, the Canadian dollar call becomes more valuable. If the Canadian dollar gets weaker, the Canadian dollar becomes less valuable. Instead of entering into a forward contract to buy Canadian dollars, the pulp-and-paper company could purchase a Canadian dollar call struck at 1.5310 for a premium from one of its financial institution counterparties. Doing so reduces their certainty about the rate at which they will repatriate the US dollars but it limits their worst case in exchange for allowing them to enjoy potential opportunity gains, again conditioned by the premium they have paid. Derivatives just like any other economic mechanism are best thought of in terms of tradeoffs. The tradeoffs here are between uncertainty and opportunity loss. However, a Canadian dollar call is only one of the possible risk management solutions to this problem. There are dozens of possible instruments, each of which has a differing tradeoff between uncertainty and opportunity loss, that the pulp-and-paper company could use to manage this exposure to changes in the exchange rate. The key to hedging is to decide which of these solutions to choose. Hedging is not just about putting on a forward contract. Hedging is about making the best possible decision, integrating the firm's level of sophistication, systems and the preferences of their shareholders. Future articles will discuss in depth the nature of some of these alternative solutions and the ways in which firms approach these other instruments.

121

HEDGING OBJECTIVES The final part of this paper will introduce briefly the notion of hedging objectives. Each of these will be discussed in articles to follow. Earlier, we noted that a hedge is a financial instrument whose sensitivity to a particular financial price offsets the sensitivity of the firm's core business to that price. Straightaway, we can see that there are a number of issues that present themselves. First, what is the hedging objective of the firm? Some of the best-articulated hedging programs in the corporate world will choose the reduction in the variability of corporate income as an appropriate target. This is consistent with the notion that an investor purchases the stock of the company in order to take advantage of their core business expertise. Other companies just believe that engaging in a forward outright transaction to hedge each of their cross-border cash flows in foreign exchange is sufficient to deem themselves hedged. Yet, they are exposing their companies to untold potential opportunity losses. And this could impact their relative performance pejoratively. Second, what is the firm's exposure to financial price risk? It is important to measure and to have on a daily basis some notion of the firm's potential liability from financial price risk. Financial institutions whose core business is the management and acceptance of financial price risk have whole departments devoted to the independent measurement and quantification of their exposures. It is no less critical for a company with billions of dollars of internationally driven revenue to do so. There are three types of risk for every particular financial price to which the firm is exposed. Transactional risks reflect the pejorative impact of fluctuations in financial prices on the cash flows that come from purchases or sales. This is the kind of risk we described in our example of the pulp-and-paper company concerned about their US$10 million contract. Or, we could describe the funding problem of the company as a transactional risk. How do they borrow money? How do they hedge the value of a loan they have taken once it is on the books? Translation risks describe the changes in the value of a foreign asset due to changes in financial prices, such as the foreign exchange rate. Economic exposure refers to the impact of fluctuations in financial prices on the core business of the firm.

122

If developing markets economies devalue sharply while retaining their high technology manufacturing infrastructure, what effect will this have on an Ottawa-based chip manufacturer that only has sales in Canada? If it means that these countries will flood the market with cheap chips in a desperate effort to obtain hard currency, it could mean that the domestic manufacturer is in serious jeopardy. Third, what are the various hedging instruments available to the corporate Treasurer and how do they behave in different pricing environments? When is it best to use which instrument is the question the corporate Treasurer must answer. The difference between a mediocre corporate Treasury and an excellent one is their ability to operate within the context of their shareholder-delineated limits and choose the optimal hedging structure for a particular exposure and economic environment. Not every structure will work well in every environment. The corporate Treasury should be able to tailor the exposure using derivatives so that it fits the preferences and the view of the senior management and the board of directors. Importance It may appear that companies in which individual investors place money do not have exposures to financial prices. After reading this article, the reader should have some notion of how dangerous a misconception that can be. The single most important point to take away from this material is that financial risk management is critical to the survival of any non-financial corporation. Investors who have real money at risk must understand the exposures facing the firms in which they invest, they must know the extent of risk management at these companies and they must be able to distinguish between good risk management programs and bad ones. Without this knowledge, they may be in for some ugly surprises.

IV. What Risks are Hedged? Predominantly derivatives are used to hedge currency risk. Next in importance comes interest rate risk and to a small extent equity risk.

V. Types of Derivatives Used The First generation derivatives instruments are the most popular, the greatest preference being for simple Forward contracts. This is followed by Second-generation instruments, namely Swaps and Futures. Some corporates also used structured derivatives, which come in the Third Generation category. The Rupee-Dollar Options would have been largely preferred, but they were not available at the time of response to the questionnaire.
123

VI. Techniques of Hedging Among the internal techniques, the natural hedge is the most chosen option indicating the desire of the corporates, to match to the extent possible, their foreign currency outflows and inflows. To a lesser extent, internal techniques of leads and lags are also used. As for the external techniques, the preference is mostly in favour of forward contracts, followed by swaps and cross-currency options. (It may be noted that at the time the questionnaire was administered, Rupee-Dollar Options was not in existence).

VII. HEDGING INSTRUMENTS FOR INDIAN FIRMS The recent period has witnessed amplified volatility in the INR-US exchange rates in the backdrop of the sub-prime crisis in the US and increased dollar-inflows into the Indian stock markets. In this context, the paper has attempted to study the choice of instruments adopted by prominent firms to stem their foreign exchange exposures. All the data for this has been compiled from the 2011-12 Annual Reports of the respective companies. It can be seen that earnings of all the firms are linked to either US dollar, Euro or Pound as firms transact primarily in these foreign currencies globally. Forward contracts are commonly used and among these firms, Ranbaxy and RIL depend heavily on these contracts for their hedging requirements. As discussed earlier, forwards contracts can be tailored to the exact needs of the firm and this could be the reason for their popularity. The tailor ability is a consideration as it enables the firms to match their exposures in an exact manner compared to exchange traded derivatives like futures that are standardised where exact matching is difficult. RIL, Maruti Udyog and Mahindra and Mahindra are the only firms using currency swaps. Swap usage is a long term strategy for hedging and suggests that the planning horizons for these companies are longer than those of other firms. These businesses, by nature involve longer gestation periods and higher initial capital outlays and this could explain their long planning horizons. Another observation is that TCS prefers to hedge its exposure to the US Dollar through options rather than forwards. This strategy has been observed among many firms recently in India. This has been adopted due to the marked high volatility of the US Dollar against the Rupee. Options are more profitable instruments in volatile conditions as they offer unlimited upside profitability while hedging the downside risk whereas there is a risk with forwards if the expectation of the exchange rate (the guess) is wrong as firms lose out on some profit. The use of Range barrier options by Infosys also suggests a strategy to tackle the high volatility of the dollar exchange rates. Software firms have a limited domestic market and rely on exports for the major part of their revenues and hence require additional flexibility in hedging when the volatility is high.
124

Another implication of this is that their planning horizons are shorter compared to capital intensive firms. It is evident that most Indian firms use forwards and options to hedge their foreign currency exposure. This implies that these firms chose short-term measures to hedge as opposed to foreign debt. This preference is possibly a consequence of their costs being in Rupees, the absence of a Rupee futures exchange in India and curbs on foreign debt. It also follows that most of these firms behave like Net Exporters and are adversely affected by appreciation of the local currency. There are a few firms which have import liabilities which would be adversely affected by Rupee depreciation. However it must be pointed out that the data set considered for this study does not indicate how the use of foreign debt by these firms hedges their exposures to foreign exchange risk and whether such a strategy is used as a substitute or complement to hedging with derivatives.

VIII. RISK MANAGEMENT POLICY AND GUIDELINES On the question of the choice between hedging partially, hedging fully, or not hedging at all, the majority of the corporates (71%), are in favour of an open-ended hedging policy (hedge partially) preferring to watch and take action. 20% of the respondents say they hedge fully and 9% of them choose not to hedge at all. Regarding risk management policy and guidelines, 50% of the responses confirm that they have a written policy. Among the others, many state that they are in the process of framing a written policy and relevant guidelines. In most cases, the policies are evolved and approved by the Board of Directors (BOD), or by a specially appointed Executive Committee (EC). In a large number of instances (42%), the risk management decisions are taken at the level of the EC and, in most other instances (35%), these decisions are taken by the Treasurer. Only in a limited number of instances (19%), does the BOD get involved in the day-to-day decisions on risk management. 70% of the respondents say that their risk management policies are structured in a strategic framework and almost the same percentage of respondents confirm that the risk management policy is framed independently, without reference to the hedging policy of the competitors. However, 30% of the respondents do take note of the policies of the competitors, while framing their own risk management policies. 50% of the respondents have a flexible posture on the role of the top management in analysing the foreign exchange exposure. They react to emergencies as and when needed. 40% of the respondents meet formally every quarter to analyse and take note of their underlying exposures. 46%of the respondents prefer to review their risk management policy on an ad-hoc basis, as and when needed. 24% of them have a quarterly review and 20%, a monthly review. 60% of the respondents prescribe an upper limit up to which a treasurer can trade in derivatives.
125

A majority of the respondents make changes in their hedging strategies, in response to fluctuations in the exchange rates. IX. ROLE OF THE TREASURY DEPARTMENT The Treasury Department plays a significant role in overseeing and/or executing the risk management function. 40% of the respondents consider their treasury department to be service centres. 28% of them view the treasury department as a cost centre. Only 20% of the respondents consider their treasury departments to be profit centres. Those who regard their treasury department as profit centres, trade almost all in forward contracts, preferring to book the contracts, wait and watch the movements of the exchange rates, cancel the bookings and then rebook again. This may undergo a change, with the current availability of rupee-dollar options. Cross-currency options and swaps are also often utilised for speculation. Only 20% of the respondents, who define their treasury department as profit centres, engage in pure speculation involving positions unrelated to their underlying exposures. The others maintain their positions related to their underlying exposures, watch the exchange rate movements and hedge with an eye on profits.

The experiences on Treasury Departments functioning as a profit centre present a mixed picture. Many firms have reported moderate to substantial gains due to treasury departments actions and decisions with an eye on income / wealth generation. Some have also conceded that their positioning proved wrong occasionally, but they were successful in timing the market on several occasions, resulting in handsome profits. Over 90% of the respondents have less than 5 people in charge of risk management in their treasury department. X. DEPENDENCE ON EXTERNAL SERVICES Market quote services appear to be the major reference point for exchange risk management decisions. There is also notable dependence on the dealers from whom the derivatives were bought, for guidance in risk management. Accounting firms seem to be the least preferred. 90% of the respondents are happy with the expertise that is outsourced. This may be an indication of the inadequacy of in-house talent, in managing exchange rate exposure. Or, it may be that outsourcing advice is found to be less expensive and more effective.

126

Factor analysis has short- three factors as the sources of guidance in exchange risk management. They are, in the order of priority, derivatives dealers, consultancies and then, in-house expertise. Banks, by virtue of their active involvement in selling derivative products, have an edge over other agencies, in being able to provide specialised information, relevant to foreign exchange risk management. XI. REVIEW AND PERFORMANCE MEASUREMENT About 60% of the respondents have a working system of review of the performance of the treasury department. Value-At- Risk (VAR), Stress or Scenario Test and Price Value of a Basis Point are among the tools widely used for evaluating the risk associated with usage of specific derivatives. 34% of the respondents that use derivatives do not have a system of evaluating risks. VAR technique was the preferred method of risk evaluation by maximum number of Indian corporate. Providing information on the use of derivatives, in the published financial statements, is not yet mandatory in India. 51% of the respondents do not make any mention about the use of derivatives, in their annual reports. 22% of them provide a brief summary, 19% of them make a mere mention and 8% of the respondents report in detail. Further, 93% of the respondents feel happy with their respective risk management practices.

CONCLUSION:
Derivative use for hedging is only to increase due to the increased global linkages and volatile exchange rates. Firms need to look at instituting a sound risk management system and also need to formulate their hedging strategy that suits their specific firm characteristics and exposures. In India, regulation has been steadily eased and turnover and liquidity in the foreign currency derivative markets has increased, although the use is mainly in shorter maturity contracts of one year or less. Forward and option contracts are the more popular instruments. Regulators had initially only allowed certain banks to deal in this market however now corporates can also write option contracts. There are many variants of these derivatives which investment banks across the world specialize in, and as the awareness and demand for these variants increases, RBI would have to revise regulations. For now, Indian companies are actively hedging their foreign exchanges risks with forwards, currency and interest rate swaps and different types of options such as call, put, cross

127

currency and range barrier options. The high use of forward contracts by Indian firms also highlights the absence of a rupee futures exchange in India. However, the Dubai Gold and Commodities Exchange in June, 2007 introduced RupeeDollar futures that could be traded on its exchanges and had provided another route for firms to hedge on a transparent basis. There are fears that RBIs ability to control the partially convertible currency will be subdued by this introduction but this issue is beyond the scope of this study. The partial convertibility of the Rupee will be difficult to control if many exchanges offer such instruments and that will be factor to consider for the RBI. The framework developed in this research is based on a mental model of a medium-to-large manufacturing company producing industrial components, as perceived by the researcher. The complex nature of the relationship between the risk elements and decision variables may often be beyond human comprehension without the aid of special diagnostic and analytical tools. Decisions and actions in the area of FERM may have impact on other segments and activities in the enterprise. A larger interactive model capable of embracing all facets of enterprise-wide risk management needs be developed. This is an area of further enquiry. The limitation of this study is that only one type of risk is assumed i.e the foreign exchange risk. Also applicability of conclusion is limited as only very few firms were reviewed over just one time period. However the results from this exploratory study are encouraging and interesting, leading us to conclude that there is scope for more rigorous study along these lines.

BIBLIOGRAPHY:
Allayannis, George and Ofek, Eli, 2001, Exchange rate exposure, hedging, and the use of foreign currency derivatives, Journal of International Money and Finance 20 (2001) 273296 Baril, Charles P.: Managing Risks with Derivatives Management Accountant, November p.34-42 ( 1996) Bauman, Joseph; Saratore, Steve and Liddle, William : A Practical Framework for Corporate Risk Management Journal of Applied Corporate Finance, Vol. 7, No. 3, Fall (1994) Bodnar, M. Gordon, Hayt, S. Gregory and Marston, C. Richard : 1998 Wharton Survey of Financial Risk Management by US Non-Financial Firms, Financial Management, Winter, Vol. 27, No. 4, pp 70-91 (1998)

128

 Broll,Udo,1993, Foreign Production and International Hedging in a Multinational Firm, Open economies review 4: 425-432 Buckley, Adrian : Multinational Finance, New Delhi: Prentice Hall of India Private Limited, (1998) Collier, P. and Davis, E. W. : The Management of Currency Transaction Risk by UK Multinational Companies, Accounting and Business Research, Autumn, pp 327-334 (1985) Cornel and Shapiro : International Financial Management, New York: John Wiley & Sons, (1985) Copeland, Tom and Copeland, Maggie: Managing Corporate Foreign Exchange Risk: A Value Maximising Approach Financial Management, Vol. 28, No. 3, pp 68-75, Autumn (1999) Cummins, David J.; Phillips, Richard D. and Smith, Stephen D. : Derivatives and Corporate Risk Management: Participation and Volume Decisions in the Insurance Industry Journal of Risk & Insurance, Vol. 68, Issue 1, pp 51-90, March ( 2001) Dash, Shridhar Kumar: Efficiency of Indian Foreign Exchange Market, Journal of Foreign Exchange and International Finance, Vol. 12, No. 1, pp 35-44 (1998) De Ceuster, Marc J.K., Durinck, Edward, Leveren, Eddy and Lodewyckx, Jozef : A Survey into the Use of Derivatives by Large Non-financial Firms Operating in Belgium, European Financial Management, Sep, Vol. 6, Issue 3, pp 301-319 (2000) Giddy, Ian H and Dufey, Gunter, 1992, The Management of Foreign Exchange Risk, Available at: http://pages.stern.nyu.edu/~igiddy/fxrisk.htm. (last accessed : March 2008) Gambhir, Neeraj and Goel,Manoj, Foreign Exchange Derivatives Market in India -Status and Prospects, Available at: http://www.iief.com/Research/CHAP10.PDF 31 Hentschel, L. and S.P. Kothari: Are Corporations Reducing or Taking Risks with Derivatives? Massachusetts Institute of Technology Working Paper July (2000) Howton, D. Shawn and Perfect, B. Steven : Currency and Interest-Rate Derivatives Use in US Firms, Financial Management, Winter, Vol. 27, No. 4, pp. 111-121 (1998)
129

 Judge, Amrit, Aug 2003, How Firms Hedge Foreign Currency Exposure: Foreign Currency Derivatives versus Foreign Currency Debt, available at http://www.mubs.mdx.ac.uk/Research/Discussion_Papers/Economics/DPAP%20 ECON%20NO.%20106.pdf (last accessed : March 2008) Muller and Verschoor, March, 2005, The Impact of Corporate Derivative Usage on Foreign Exchange Risk Exposure, Available at http://ssrn.com/abstract=676012 Soenen L.A and Madura, Jeff, 1991, Foreign Exchange Management: A Strategic Approach, Long Range Planning, Vol. 24, NO. 5, pp. 119 to 124. Soenen, L.A, 1979, Efficient Market Implications for Foreign Exchange Exposure Management, DE ECONOMIST 127, NR. 2. Asani Sarkar, 2006, Indian Derivative Markets from the Oxford Companion to Economics in India. Available at http://www.newyorkfed.org/research/economists/sarkar/derivatives_in_india.pdf Woochan Kim and Taeyoon Sung, June 2005, What makes firms manage FX risk?, , Emerging Markets Review 6 (2005) 263 288 http://www.ril.com/rportal/jsp/eportal/ListDownloadLibrary.jsp?DLID=866 http://www.infosys.com/investor/reports/annual/Infosys_AR06.pdf http://www.arvindmills.com/finance/docs/qtr/0405/Arvind%20Mills%20Annual% 20Report%20for%202008-09.pdf http://www.rbi.org.in/Scripts/BS_FemaNotifications.aspx Meera, Ahamed Kameel Mydin,2004 Hedging Foreign Exchange Risk withForwards, Futures, Options and the Gold Dinar: A Comparison Note available at:http://www.americanfinance.com/knowledge-center/articles/pdf/Malaysia%20 %20GOLD%20-%20Hedging%20With%20Dinar.pdf Chitale, Rajendra P., 2003, Use of Derivatives by Indias Institutional Investors: Issues and Impediments, in Susan Thomas (ed.), Derivatives Markets in India, Tata McGraw- Hill Publishing Company Limited, New Delhi, India.
130

FitchRatings, 2004, Fixed Income Derivatives---A Survey of the Indian Market, www.fitchratings.com

Gambhir, Neeraj and Manoj Goel, 2003, Foreign Exchange Derivatives Market in India-- -Status and Prospects, Susan Thomas (ed.), Derivatives Markets in India, Tata McGraw- Hill Publishing Company Limited, New Delhi, India.

Gorham, Michael, Thomas, Susan and Ajay Shah, 2005, India: The Crouching Tiger, Futures Industry. Lee, Rupert, 2004, Seeing Double, FOW. ISMR, Indian Securities Market: A Review, 2004, National Stock Exchange of India Limited, Mumbai, India. Jogani, Ashok and Kshama Fernandes, 2003, Arbitrage in India: Past, Present and Future, in Susan Thomas (ed.), Derivatives Markets in India, Tata McGraw-Hill Publishing Company Limited, New Delhi, India.

Nair, C. G. K., 2004, Commodity Futures Markets in India: Ready for Take Off? National Stock Exchange of India Limited, Mumbai, India. https://docs.google.com/viewer?a=v&q=cache:vgRVmRZlM9AJ:people.bath.ac.uk/m nsanb/MN20211Chapter5ForeignExchangeRiskManagement.doc+concept+of+foreig n+exchange+risk+management&hl=en&gl=in&pid=bl&srcid=ADGEESj2F4nyfkLV Ul3rVrbgAS_4dKauKOPsF6rvAl13YItabu4CRdRreUShtckPvFqpp9rF0r6hY5AwELSbuxDHrrKqBcHS_pobywx8eSAD4vtSl9hH2GUSYwlgv6Yl7Q aXasplAzW&sig=AHIEtbTOSvasLw6seySuuOFbpSOq5moZkg https://docs.google.com/viewer?a=v&q=cache:ZZ7RyscbFkgJ:www.desjardins.com/e n/entreprises/solutions/services-internationaux/devises-etrangeres/ge-risquechange.pdf+concept+of+foreign+exchange+risk+management&hl=en&gl=in&pid=bl &srcid=ADGEESgkLD2K-syEkZeDI-zzI maNCoxVP59xUvyPd8XY6MZ32xlmfS5hBEoXdSWFckBc4biM4Kovq2HYMqPd5 -5fcErRmqkGtrqGpB3aefyqKRPhPwGLCn2-QunlZ1jqPuNgIpbTml&sig=AHIEtbSA GBIhzjhQyohZ8lDNLihvh9fPA https://docs.google.com/viewer?a=v&q=cache:5bvAOMBdP90J:trade.gov/media/pub lications/pdf/tfg2008ch12.pdf+concept+of+foreign+exchange+risk+management&hl
131

=en&gl=in&pid=bl&srcid=ADGEEShSz_rW1_cqeqYGoJMapoFflyTqB 2w7LSR8PMX9IR0gbDDhu7puwb2FcdQ-5Cp5YcMK OcPzWSPU5dd172E8wJP4B_ovIRE5zTLAg4Ih9 _L7fqagHBvThbFHZMeCb6kh_S7OJ&sig=AHIEtbTyK7ZfKBr91x5l3t8miNZhOB mU3w International Financial Management,5/e P.G.Apte, Tata McGraw-Hill Publication, 2009. International Finance,2/e Thomas J.OBrien, Oxford Publication, 2007 https://docs.google.com/viewer?a=v&q=cache:yC5qgRyl3z0J:nptel.iitm.ac.in/courses /110105031/pr_pdf/Module21%2520pdf..pdf+types+of+foreign+exchange+exposure+and+risk&hl=en&gl=in&p id=bl&srcid=ADGEESi7IwGUmL6Ejo6AyD18qwUB0d77iNqtWyW7iiIRStzgjHv2 wGsflo41fltvdzSDCSGlNZRP0E_f3o7JpjMZuAPjLtRYnTD4Kx-9TLwFIY7JZUTPd4-lzqeL2qPojqz6UYYukA &sig=AHIEtbRtkLCMXiq_GpH5ri1TyW0iyPQjVg

132