Forex Srikant

“Unveiling Foreign Exchange Market
Exposure Modeling and Forex Risk

Management by Indian Commercial
Banks”
Submitted By:
Srikant Sharma
Roll No-29/09(F)
Under the Guidance of

Prof. Deepak Tandon
Lal Bahadur Shastri Institute of Management,
Delhi
08th September 2010
FOREIGN EXCHANGE MARKET

Project Study Approval Performa
(To be approved by the project guide)
1. Name of the Candidate: SRIKANT SHARMA Roll No.:

29/09(F)
2. Topic:Unveiling Foreign Exchange Market

Exposure Modeling and Forex Risk Management
by Indian Commercial Banks.
3. Name of the Guide: Prof. DEEPAK TANDON
SIGNATURE OF THE GUIDE
UNDERTAKING

I, Srikant Sharma, a student of Lal Bahadur Shastri Institute of Manageme
nt, New Delhi of PGDM (Fin) 2009-11, Sec-C, hereby declare that the end term
project report titled “Unveiling Foreign Exchange Market Exposure Modeling an
d Forex Risk Management by Indian Commercial Banks)” in the academic Year
2009-2011 towards the completion of End Term Project in 2nd Year of PGDM as
partial fulfillment for the requirement of the two year Post Graduate Diploma i
n Management (Finance) is an authentic record of work carried out under the g
uidance of Prof. Deepak Tandon.
Srikant Sharma
ACKNOWLEDGEMENT
Surpassing milestones towards a mission sometimes gives us such degree of jubilance
that we tend to forfeit the precious guidance and help extended by the people to
whom the success of mission is solely dedicated.
A project of this magnitude depends on contributions from a wide range of people for
its success. I would like to take this opportunity to acknowledge the many people who
have contributed a great deal of their time and expertise to the development of this
project.
Firstly, I express my sincere thanks to my immediate guide, Prof. Deepak Tandon,

Prof. at Lal Bahadur Shastri Institute of Management, Delhi for getting me started &
for seeing me through until the end. Needless to say, without his knowledge, guidance
and experience, this project would not have gone beyond. He has been a source of
constant inspiration, stimulating me to learn and pick up minutiae of the topic, making
my learning process an enlightening experience. He has given a sense of
completeness to this project and ensured its full proof by completely monitoring my
work.
Finally, a note of thanks is due to all those, too many to single out by names, who
have helped in no small measure by cooperating during the project and by providing
their valuable time, inputs and assistance.
At the same time I would also like to thank my professors of institute for their kind
support during time of summer training.
Finally I would like to thank LBSIM for facilitating such a study in Post Graduate
Program helping us practical aspects of our course.

LITERATURE REVIEW
If there were only one currency in the world, there would not have been any
need for foreign exchange market, foreign exchange rates or foreign exchange.
But in a world of many national currencies, the foreign exchange market plays
the crucial role of providing the requisite machinery for making payments
across borders, transferring funds and purchasing power from one currency to
another, and determining the exchange rate.
All the parts of the economy are interconnected and have a mutual impact on
each other. Currency is one of the most important instruments of the economic
processes that at the same time influences them and falls under their
influence. Changes in the economy environment have an effect on the
currency rate while on the other hand currency rate can underlie many
business decisions and economy trends. Hence if an individual wants to
conduct international business one need to exchange one currency for another
that is accepted at a certain territory. The main factors that drive the currency
to move from one edge to another are demand and supply, interest rates,
economic indicators, political stability and future performance of one currency
against another. The need to exchange currencies is the primary reason why
the forex market is the largest, most liquid financial market in the world.
This throws light on the relevance of rupee movement and the importance of
rupee products at the same time.Some form of risk taking is inherent to any
business activity. And in matters of currency it runs very high. With currency
trading evolving as huge market, it is important to cover the risks involved in
case of a huge unexpected downfall. The basic principle for accessing domestic
foreign exchange markets is hedging of underlying foreign exchange
exposures. In keeping with the evolution of the foreign exchange market and
the increase in depth and volumes, a range of hedging instruments have been
permitted to market participants, but most common amongst them in the
Indian market are the Forwards. Now the aim of this project is to compare the
forwards of one bank with forwards of other banks and do an analytical study,
which shall facilitate one with the crucial information of the bank product
offerings, and market moves. This shall provide us with relevant information
required for the better positioning of the banks Product.

TABLE OF CONTENTS:
Objective of the
Study……………………………………………………………………………………… 8
Introduction of Forex Market

……………………………………………………………………………………9
Market
Participants……………………………………………………………………………………10-
11
Attractive Features of
Market……………………………………………………………………………………12
Margin Trading
System……………………………………………………………………………………13
Analyzing Forex
Market……………………………………………………………………………………14-15
Exchange Rates-
……………………………………………………………………………………16-17
-Direct Exchange Rates
-Indirect Exchange Rates
-Spot Rate
-Forward Rate
-Cross Rate
-Merchant Rate
Foreign Exchange
Risks……………………………………………………………………………………18-20
-Translation Exposure
-Transaction Exposure
-Economic Exposure
Risks……………………………………………………………………………………21
-Country Risk
-Cross Cultural Risk
-Commercial Risk
-Currency Risk
Necessity of Managing
Risks……………………………………………………………………………………22
Hedging as a tool to manage

Risk……………………………………………………………………………………22

Foreign Risk Management
Framework……………………………………………………………………………23
Hedging
Instruments……………………………………………………………………………………23-
25
-Forwards
-Futures
-Options
-Swaps
-Foreign Debt
Choice of Hedging
Instruments………………………………………………………………………………26
An Overview of Hedging in
India……………………………………………………………………………………26-28
- Case Study
-
Calculation of Market Risk Using VaR Model-
………………………………………………………29
- Parametric Approach
- Non-Parametric Approach
Factors Influencing the Foreign Exchange

Rates…………………………………………………………31
- Inflation Rate
- Interest Rate
- Current Account Deficit
- Public Debt
- Political Stability and Economic Performance
Analysis of Foreign Exchange Rates…………………………………………………………

33
Case Studt…………………………………………………………35-45
Conclusion ………………………………………………………… 46
Bibliography …………………………………………………………47

OBJECTIVE:
 To understand and analysis of Current India Forex Market.
 To study the major participants of Forex Market.
 To carry out primary research for data collection.
 To understand the product offering of the other banks.
 To find the Risks associated with the Forex Market.
 To calculate the Market Risk using VaR Technique.
 To understand the Forex Risk Management.
o Currency Fluctuation
o Currency Hedge
o Design a Hedging strategy
o Basics Hedging Techniques
o To Hedge or not to hedge
Methodology
1. To access risk exposure of the dealers with the corporate at the banks.
Analytically examine the impact of exchange rate fluctuation in India and its
impact on corporate clients. To access the transaction cost and hedging
decisions by the corporate by the Forex dealer and to study the framework of
foreign risk estimation and hedging decision by category A authorized dealer.
2. Calculation of Market Risk associated with Forex using VaR Model.

3. To state an overview of the corporate hedging in India through
authorized dealers. Viz. Swaps , Forwards, Options and the scope of
Currency Swaps in India.
4. Primary data shall be collected and interpolated with the help of

statistical tool and bring out the best possible profit maximization under
provision of FEMA.
INTRODUCTION
FOREIGN EXCHANGE MARKET:
Foreign Exchange Market is an inter-bank market that took shape in 1971

when global trade shifted from fixed exchange rates to floating ones. This is a
set of transactions among forex market agents involving exchange of specified
sums of money in a currency unit of any given nation for currency of another
nation at an agreed rate as of any specified date. During exchange, the
exchange rate of one currency to another currency is determined simply: by
supply and demand – exchange to which both parties agree.
During 2003-04 the average monthly turnover in the Indian foreign exchange
market touched about 175 billion US dollars. Compare this with the monthly
trading volume of about 120 billion US dollars for all cash, derivatives and debt
instruments put together in the country, and the sheer size of the foreign
exchange market becomes evident. Since then, the foreign exchange market
activity has more than doubled with the average monthly turnover reaching
359 billion USD in 2005-2006, over ten times the daily turnover of the Bombay
Stock Exchange. As in the rest of the world, in India too, foreign exchange
constitutes the largest financial market by far. According to the Bank for
International Settlements, average daily turnover in global foreign exchange
markets is estimated at $3.98 trillion, as of April 2010 a growth of
approximately 20% over the $3.21 trillion daily volume as of April 2007.
Liberalization has radically changed India’s foreign exchange sector. Indeed the
liberalization process itself was sparked by a severe Balance of Payments and
foreign exchange crisis. Since 1991, the rigid, four-decade old, fixed exchange
rate system replete with severe import and foreign exchange controls and a
thriving black market is being replaced with a less regulated, “market driven”
arrangement. While the rupee is still far from being “fully floating” (many
studies indicate that the effective pegging is no less marked after the reforms
than before), the nature of intervention and range of independence tolerated
have both undergone significant changes. With an over- abundance of foreign
exchange reserves, imports are no longer viewed with fear and skepticism. The
Reserve Bank of India and its allies now intervene occasionally in the foreign
exchange markets not always to support the rupee but often to avoid an
appreciation in its value. Full convertibility of the rupee is clearly visible in the
horizon. The effects of these developments are palpable in the explosive
growth in the foreign exchange market in India.
Another essential feature of the FOREX market, no matter how strange it might
seem, is its stability. Everybody knows that sudden falls are very typical of the
financial market. However, unlike the stock market, the FOREX market never
falls. If shares devalue it means a collapse. But if the dollar slumps, that only
means that another currency gets stronger. For instance, the yen strengthened
by a quarter against the dollar late in 1998. On some days dollar fell by dozens
percentage points. However, the market did not collapse anywhere; trading
continued in the usual manner. It is here that the market and the related
business stability lie - currency is an absolutely liquid commodity and will be
always traded in.
MARKET PARTICIPANTS
BANKS:
Inter banks market is at the top in forex trading. Inter-bank market accounts
53% of total transaction of the forex. Some of this trading is done on the behalf
of the customers, but proprietary desks, trading for bank’s own account,
conduct most. Today more of the trading business has moved on to more
efficient electronics system.
COMMERCIAL COMPANIES:
Commercial companies play an important role in the forex market. They do

participate in forex trading to pay activities and goods they are using in
international market. Trading is done on current exchange rate. The amount of
trading by commercial companies is very less than the bank’s or speculator’s
account in forex. Hence commercial companies have less impact on the
exchange rate.
CENTRAL BANK:
The central bank RBI (India) plays an important role in the forex market. The
central bank controls the liquidity of the foreign exchange market. They try to
control money supply, inflation and exchange rates.
HEDGERS:

Some of the biggest clients of these banks are businesses that deal with
international transactions. Whether a business is selling to an international
client or buying from an international supplier, it will need to deal with the
volatility of fluctuating currencies. If there is one thing that management (and
shareholders) detest, it is uncertainty. Having to deal with foreign-exchange
risk is a big problem for many multinationals. For example, suppose that a
German company orders some equipment from a Japanese manufacturer to be
paid in yen one year from now. Since the exchange rate can fluctuate wildly
over an entire year, the German company has no way of knowing whether it
will end up paying more Euros at the time of delivery.
One choice that a business can make to reduce the uncertainty of foreign-
exchange risk is to go into the spot market and make an immediate transaction
for the foreign currency that they need. Unfortunately, businesses may not
have enough cash on hand to make spot transactions or may not want to hold
massive amounts of foreign currency for long periods of time. Therefore,
businesses quite frequently employ hedging strategies in order to lock in a
specific exchange rate for the future or to remove all sources of exchange-rate
risk for that transaction.
For example, if a European company wants to import steel from the U.S., it
would have to pay in U.S. dollars. If the price of the euro falls against the dollar
before payment is made, the European company will realize a financial loss. As
such, it could enter into a contract that locked in the current exchange rate to
eliminate the risk of dealing in U.S. dollars. These contracts could be either
forwards or futures contracts.
SPECULATORS:
Another class of market participants involved with foreign exchange-related

transactions is speculators. Rather than hedging against movement in
exchange rates or exchanging currency to fund international transactions,
speculators attempt to make money by taking advantage of fluctuating
exchange-rate levels.
RETAIL FOREIGN EXCHANGE BROKER:
IMPORTERS:
Who may need to purchase their supplier’s domestic currency to pay for the
goods he has supplied.
EXPORTERS:
Who may be paid a foreign currency by an overseas purchaser, and who need
to convert it into his or her own currency.
TOURISTS:
Who often purchase foreign currency, traveler’s cheques and bank notes, prior
to visiting an overseas country.
ATTRACTIVE FEATURES OF THE MARKET

Liquidity: The market operates the enormous money supply and gives absolute
freedom in opening or closing a position in the current market quotation. High
liquidity is a powerful magnet for any investor, because it gives him or her the
freedom to open or to close a position of any size whatever.
Promptness: With a 24-hour work schedule, participants in the FOREX market

need not wait to respond to any given event, as is the case in many markets.
Availability: A possibility to trade round-the-clock; a market participant need

not wait to respond to any given event.
Flexible regulation of the trade arrangement system: A position may be opened

for a pre-determined period of time in the FOREX market, at the investor’s
discretion, which enables to plan the timing of one’s future activity in advance.
Value: The Forex market has traditionally incurred no service charges, except
for the natural bid/ask market spread between the supply and the demand
price.
One-valued quotations: With high market liquidity, most sales may be carried
out at the uniform market price, thus enabling to avoid the instability problem
existing with futures and other forex investments where limited quantities of
currency only can be sold concurrently and at a specified price
Market trend: Currency moves in a quite specific direction that can be tracked
for rather a long period of time. Each particular currency demonstrates its own
typical temporary changes, which presents investment managers with the
opportunities to manipulate in the FOREX market.
Margin: The credit “leverage” (margin) in the FOREX market is only determined
by an agreement between a customer and the bank or the brokerage house
that pushes it to the market and is normally equal to 1:100. That means that,
upon making a $1,000 pledge, a customer can enter into transactions for an
amount equivalent to $100,000. It is such extensive credit “leverages”, in
conjunction with highly variable currency quotations, which makes this market
highly profitable but also highly risky.
MARGIN TRADING SYSTEM

A typical transaction amounts to $10 million in inter-bank trade. However, it is
quite clear that such transaction values are not affordable for a private investor
– well, at least to the overwhelming majority of them.

Involvement of small and medium investors in the Forex market was facilitated
by intermediacy of dealing or brokerage companies. Medium and small
investors have access to the global forex market in many nations, using the
sums of money starting from $2,000 in their transactions. A dealing company
provides its customers with a credit line – a so-called dealing leverage, or a
credit leverage, that is several times as big as the deposit. Brokers providing
margin trading services require that a pledge deposit should be contributed,
and provide a customer with an opportunity of entering into forex sales and
purchase transactions for amounts that are 50, 100 and sometimes even 200
times as large as the deposit made. The risk of losses is borne by the
customer; the deposit serves as security hedging a broker. The system of
operations through a dealing (brokerage) house, with credit leverage, was
called margin trading.
To put it simply, the essence of margin trading can be reduced to the following:
by placing pledged capital, an investor becomes able to manage target loans
provided against this pledge and to guarantee indemnification against any
potential losses on open forex positions with the deposit.
As mentioned above, unlike with forex transactions with actual delivery or

actual currency exchange, FOREX participants, especially those with little
funds, make use of trading with an insurance deposit - margin trade, or
leverage trade. In case of marginal trade, each transaction must consist of the
two stages – purchase/sales of foreign exchange at one price, and then its
compulsory sales/purchase at another (or at the same) price. The first action is
called the opening of a position; the second is the closing of a position.
Opening of a position is not accompanied with actual delivery of foreign
exchange, and a participant that opened the position contributes an insurance
deposit that serves as guarantee of indemnification against any possible
losses. Upon closing of a position, the insurance deposit is returned, and profit
or losses are calculated.
Any margin trading transaction must comprise two parts: opening of a position
and closing of a position. For instance, when forecasting the euro goes up
(looks up) vs the dollar, we want to buy a cheaper euro with dollars now and to
sell it back when it rises in price. In this case, the transaction will look as
follows: opening of a position – euro purchase; closing of a position – its sale.
All the time until the position has been closed we have an “open euro position.”
Just the same, when we believe that the euro will cheapen (look down) vs the
dollar, our transaction will consist of the following steps: opening a position –
sales of a more expensive euro; closing a position – purchase of a cheapened
euro. Therefore, we are able to generate profit whether the exchange rate goes
up or down.
You can enter FOREX through an intermediary only. A dealing center may act
as such intermediary. This agency provides you with a (computer or telephone)
communications channel with a broker who makes available forex quotations
to you and through whom you can enter into transactions. You can also operate
directly from your home PC through the Internet. The last option has been
becoming increasingly more common recently. The prices you can see on your
computer’s screen are prices of actual transactions at FOREX.

Margin trading appeals by its affordability. Investing funds into securities of the
most developed foreign countries to generate any fixed income would hardly
be interesting for our compatriots. U.S. Treasury bonds are surely the most
reliable and stable, but, being very expensive, they have low yield (approx. 6%
p.a.) and are the object of long-term investments. Shares generate higher
yield; however, dividend amount is directly dependent on successful operations
of any particular enterprise and its shareholders’ preferences. Share purchase
for bull transactions seems more attractive but requires greater investments.
Margin trading is free from the said limitations – you can sell and buy
depending on your expectations, and 1%-3% of a transaction value will do to
enter into the transaction.
ANALYZING FOREX MARKET

There are two basic approaches to analyzing the Forex market. It is important
to understand how they can be used successfully.
TECHNICAL ANALYSIS:
Technical Analysis focuses on the study of price movements, using historical
currency data to try to predict the direction of future prices. The premise is
that all available market information is already reflected in the price of any
currency, and that all you need to do is study price movements to make
informed trading decisions.
The primary tools of Technical Analysis are charts. Charts are used to identify
trends and patterns in an attempt to find profit opportunities. Those who follow
this approach look for trending tendencies in the Forex markets, and say that
the key to success is identifying such trends in their earliest stage of
development.
FUNDAMENTAL ANALYSIS:
Fundamental Analysis focuses on the economic, social, and political forces that
drive supply and demand. The premise is that macroeconomic indicators such
as economic growth rates, interest rates, inflation, and unemployment can be
used to make informed trading decisions.
Traders using Technical Analysis follow charts and trends, typically following a
number currency pairs simultaneously. Traders using Fundamental Analysis
must sort through a great deal of market data, and so typically focus on only a
few currency pairs. For this reason, many traders prefer Technical Analysis.
In addition, many traders choose Technical Analysis because they see strong
trending tendencies in the Forex market. They look to master the fundamentals
of Technical Analysis and apply them to numerous time frames and currency
pairs.
EXCHANGE RATES
There are 2 ways of quoting Exchange Rates:
Direct Exchange Rates:
The exchange rate for a foreign currency is expressed in terms of units of local
currency equal to one unit of foreign currency.
USD 1.00 = INR 44.50 [Direct Quote for US dollar in India]
In a direct quotation, the home currency is the price (numerator) and the
foreign currency is the commodity (denominator)
Indirect Exchange Rates:
The exchange rate is quoted in terms of the number of units of foreign

currency equal to a unit of local currency.
USD2.3529 = INR 100 [Indirect quotation in India for the US dollar]
In an indirect quotation, the home currency is the commodity (denominator)

and the foreign currency is the price (numerator)
In India, all quotations are now in terms of Direct Rates
European terms convention – Almost all exchange rates are expressed as

direct quotations from a non-American perspective (indirect quotations from an
American perspective); that is, the dollar is the commodity in the denominator
The most important exceptions are the British pound (GBP) and the Euro (EUR),
which are quoted in American terms; that is, the dollar is the price in the
numerator. Other currencies quoted in American terms are the Australian
dollar, the New Zealand dollar, the Botswana pula, the Cyprus pound, and the
Maltese lira.
This convention means that exchange rates are usually quoted in a form in
which they are greater than 1.
There are two main types of foreign exchange rates that may be used in
foreign exchange transactions.
Spot rate - The spot rate is the exchange rate used for foreign exchange
transactions that will be settled in 2 working days time.
Example:
The yen exchange rate is 154.20/30
The dealer buys a dollar for 154.20 yen
The dealer sells a dollar for 154.30 yen
A point is .01 yen; the spread is .10 yen (10 points)
Forward rate - The forward rate is the exchange rate used for transactions that
will be settled beyond 2 working days.

Cross-rates - Rates between any two currencies can be obtained by multiplying
or dividing their rates with respect to the dollar
A cross rate is as if you are selling (buying) one currency and buying (selling)
the dollar and then selling (buying) the dollar and buying (selling) the other
currency
When you write the transactions out, the dollars cancel out leaving the other
two currencies.
Example:
Case 1: A bank that is a market maker, at what rate would buy INR and Sell
HKD if the spot rates are:
USD/INR: 45.85-90
USD/HKD: 7.8010-20
What Rate Would You Purchase At?
USD/INR: 45.85-90
USD/HKD: 7.8010-20
As a market maker the bank buys INR and Sells HKD
Transaction 1: Bank sells USD and buys INR at 45.90 [Hint: Higher Price] => 1
USD =45.90INR
Transaction 2: Bank buys USD and sells HKD at 7.8010[Hint: Lower Price] =>1
USD = 7.8010HKD
45.90INR=7.8010 HKD
1 INR =0.169 HKD
So Bank will buy 1 INR and sell HKD @ 0.169.
MERCHANT RATE
Buying Rate
Merchant rates are rates quoted to the customers by banks. Buying and selling
rates are further subdivided depending upon different business transactions.
TT buying- Rate at which a Foreign Inward Remittance received by telegraphic

transfer is converted into rupees.
TT Buying rate = Interbank Buying Rate - Exchange margin

Selling Rate
TT Selling –Rate applicable when a customer sends an outward remittance

through telegraphic transfer
TT Selling rate = Interbank Selling rate + Exchange margin
Bids and Asks
The dealer buys the commodity currency at the bid price and sells it at the ask
price; therefore, the customer sells the commodity currency at the bid price
and buys it at the ask price
The bid price is always less (a smaller number) than the ask price.
Every exchange rate can be expressed as a reciprocal; however, the reciprocal

of the bid is the ask (the commodity currency changes, and the currency the
dealer is buying becomes the price currency, and the currency the dealer is
selling becomes the commodity)
Foreign Exchange Risk

When companies conduct business across borders, they must deal in foreign
currencies . Companies must exchange foreign currencies for home currencies
when dealing with receivables, and vice versa for payables. This is done at the
current exchange rate between the two countries. Foreign exchange risk is the
risk that the exchange rate will change unfavorably before the currency is
exchanged. Foreign exchange risk is linked to unexpected fluctuations in the
value of currencies. A strong currency can very well be risky, while a weak
currency may not be risky. The risk level depends on whether the fluctuations
can be predicted. Short and long-term fluctuations have a direct impact on the
profitability and competitiveness of business.
Kinds of Exposures
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.
There are mainly three types of foreign exchange exposures:
o Translation exposure
o Transaction exposure
o Economic Exposure

Translation Exposure
It is the degree to which a firm’s foreign currency denominated financial

statements is affected by exchange rate changes. All financial statements of a
foreign subsidiary have to be translated into the home currency for the
purpose of finalizing the accounts for any given period. If a firm has
subsidiaries in many countries, the fluctuations in exchange rate will make the
assets valuation different in different periods. The changes in asset valuation
due to fluctuations in exchange rate will affect the group’s asset, capital
structure ratios, profitability ratios, solvency ratios, etc. FASB 52 specifies that
US firms with foreign operations should provide information disclosing effects
of foreign exchange rate changes on the enterprise consolidated financial
statements and equity. The following procedure has been followed:
Assets and liabilities are to be translated at the current ratethat is the rate
prevailing at the time of preparation of consolidated statements.
All revenues and expenses are to be translated at the actual exchange rates
prevailing on the date of transactions. For items occurring numerous times
weighted averages exchange rates can be used.
Translation adjustments (gains or losses) are not to be charged to the net

income of the reporting company. Instead these adjustments are accumulated
and reported in a separate account shown in the shareholders equity section of
the balance sheet, where they remain until the equity is disposed off.
Measurement of Translation exposure
Translation exposure = (Exposed assets - Exposed liabilities)*(change in the

exchange rate)
Transaction Exposure
This exposure refers to the extent to which the future value of firm’s domestic
cash fl0w is affected by exchange rate fluctuations. It arises from the
possibility of incurring foreign exchange gains or losses on transaction already
entered into and denominated in a foreign currency. The degree of transaction
exposure depends on the extent to which a firm’s transactions are in foreign
currency. For example, the transaction in exposure will be more if the firm has
more transactions in foreign currency. According to FASB 52, all transaction
gains and losses should be accounted for and included in the equity’s net
income for the reporting period. Unlike translation gains and loses which
require only a bookkeeping adjustment, transaction gains and losses are
realized as soon as exchange rate changes. The exposure could be interpreted
either from the standpoint of the affiliate or the parent company. An entity

cannot have an exposure in the currency in which its transactions are
measured.
Economic Exposure
Economic exposure refers to the degree to which a firm’s present value of

future cash flows can be influenced by exchange rate fluctuations. Economic
exposure is a more managerial concept than an accounting concept. A
company can have an economic exposure to say Pound/Rupee rates even if it
does not have any transaction or translation exposure in the British currency.
This situation would arise when the company’s competitors are using British
imports. If the Pound weakens, the company loses its competitiveness (or vice
versa if the Pound becomes strong). Thus, economic exposure to an exchange
rate is the risk that a variation in the rate will affect the company’s competitive
position in the market and hence its profits. Further, economic exposure affects
the profitability of the company over a longer
time span than transaction or translation exposure. Under the Indian exchange
control, economic exposure cannot be hedged while both transaction and
translation exposure can-be hedged.
There are some other risks also in International Market:
1 Country Risk:
Exposure to potential loss or adverse effects on company operations and

profitability caused by developments in a country‘s political or legal
environments. It could be due to:
o Govt. Intervention, red tape, corruption
o Lack of legal safeguards for intellectual property rights
o Legislation unfavorable to foreign firms
o Economic failures and mismanagement
o Social and political unrest and instability
2 Cross Cultural Risk:
A situation or event where cultural miscommunication puts some human value

at stake.
3 Commercial Risks:
Exposure to market preferences and sentiments. This relates to establishing

credibility and taking much more trouble to settle down than the home- grown
company.
4 Currency Risk:

Change in foreign exchange rates may result in huge amount of losses for an
MNC. Thus this is again a risk, which needs to be tackled.
Necessity of managing forex risk :
A key assumption in the concept of foreign exchange risk is that exchange rate
changes are not predictable and that this is determined by how efficient the
markets for foreign exchange are. Research in the area of efficiency of foreign
exchange markets has thus far been able to establish only a weak form of the
efficient market hypothesis conclusively which implies that successive changes
in exchange rates cannot be predicted by analyzing the historical sequence of
exchange rates.(Soenen, 1979). However, when the efficient markets theory is
applied to the foreign exchange market under floating exchange rates there is
some evidence to suggest that the present prices properly reflect all available
information.(Giddy and Dufey, 1992). This implies that exchange rates react to
new information in an immediate and unbiased fashion, so that no one party
can make a profit by this information and in any case, information on direction
of the rates arrives randomly so exchange rates also fluctuate randomly. It
implies that employing resources to predict exchange rate changes cannot do
with foreign exchange risk management away.
Hedging as a tool to manage foreign exchange risk

There is a spectrum of opinions regarding foreign exchange hedging. Some
firms feel hedging techniques are speculative or do not fall in their area of
expertise and hence do not venture into hedging practices. Other firms are
unaware of being exposed to foreign exchange risks. There are a set of firms
who only hedge some of their risks, while others are aware of the various risks
they face, but are unaware of the methods to guard the firm against the risk.
There is yet another set of companies who believe shareholder value cannot be
increased by hedging the firm’s foreign exchange risks as shareholders can
themselves individually hedge themselves against the same using instruments
like forward contracts available in the market or diversify such risks out by
manipulating their portfolio. (Giddy and Dufey, 1992).
There are some explanations backed by theory about the irrelevance of

managing the risk of change in exchange rates. For example, the International
Fisher effect states that exchange rates changes are balanced out by interest
rate changes, the Purchasing Power Parity theory suggests that exchange rate
changes will be offset by changes in relative price indices/inflation since the
Law of One Price should hold. Both these theories suggest that exchange rate
changes are evened out in some form or the other. Also, the Unbiased Forward
Rate theory suggests that locking in the forward exchange rate offers the same
expected return and is an unbiased indicator of the future spot rate. But these
theories are perfectly played out in perfect markets under homogeneous tax
regimes. Also, exchange rate-linked changes in factors like inflation and
interest rates take time to adjust and in the meanwhile firms stand to lose out
on adverse movements in the exchange rates.
The existence of different kinds of market imperfections, such as incomplete

financial markets, positive transaction and information costs, probability of
financial distress, and agency costs and restrictions on free trade make foreign
exchange management an appropriate concern for corporate management.
(Giddy and Dufey, 1992) It has also been argued that a hedged firm, being less
risky can secure debt more easily and this enjoy a tax advantage (interest is
excluded from tax while dividends are taxed). This would negate the
Modigliani-Miller proposition as shareholders cannot duplicate such tax
advantages.
The MM argument that shareholders can hedge on their own is also not valid
on account of high transaction costs and lack of knowledge about financial
manipulations on the part of shareholders. There is also a vast pool of research
that proves the efficacy of managing foreign exchange risks and a significant
amount of evidence showing the reduction of exposure with the use of tools for
managing these exposures. In one of the more recent studies, Allayanis and
Ofek (2001) use a multivariate analysis on a sample of S&P 500 non-financial
firms and calculate a firms exchange-rate exposure using the ratio of foreign
sales to total sales as a proxy and isolate the impact of use of foreign currency
derivatives (part of foreign exchange risk management) on a firm’s foreign
exchange exposures. They find a statistically significant association between
the absolute value of the exposures and the (absolute value) of the percentage
use of foreign currency derivatives and prove that the use of derivatives in fact
reduce exposure.
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.
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.
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 problems4 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.
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.
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.
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.
Reporting and Review: Risk management policies are typically subjected to

review based on periodic reporting. The reports mainly include profit/ loss
status on open contracts after marking to market, the actual exchange/
interest rate achieved on each exposure, and profitability vis-à-vis the
benchmark and the expected changes in overall exposure due to forecasted
exchange/ interest rate movements. The review analyses whether the
benchmarks set are valid and effective in controlling the exposures, what the
market trends are and finally whether the overall strategy is working or needs
change.
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 can’t 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-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 today’s 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.

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, Géczy 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.
An Overview of Hedging in India

The move from a fixed exchange rate system to a market determined one as
well as the development of derivatives markets in India have followed with the
liberalization of the economy since 1992. In this context, the market for
hedging instruments is still in its developing stages. In order to understand the
alternative hedging strategies that Indian firms can adopt, it is important to
understand the regulatory framework for the use of derivatives here.
Development of Derivative Markets in India
The economic liberalization of the early nineties facilitated the introduction of

derivatives based on interest rates and foreign exchange. Exchange rates were
deregulated and market determined in 1993. By 1994, the rupee was made
fully convertible on current account. The ban on futures trading of many
commodities was lifted starting in the early 2000s. As of October 2007, even
corporate have been allowed to write options in the atmosphere of high
volatility. Derivatives on stock indexes and individual stocks have grown
rapidly since inception. In particular, single stock futures have become hugely
popular. Institutional investors prefer to trade in the Over-The-Counter(OTC)
markets to interest rate futures, where instruments such as interest rate swaps
and forward rate agreements are thriving. 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. The typical forward contract is for one month, three months,
or six months, with three months being the most common. The Indian rupee,
which is being traded on the Dubai Gold and Commodities Exchange (DGCX),
crossed a turnover of $23.24 million in June 2007.
Regulatory Guidelines for the use of Foreign Exchange Derivatives

With respect to foreign exchange derivatives involving rupee, residents have
access to foreign exchange forward contracts, foreign currency-rupee swap
instruments and currency options – both cross currency as well as foreign
currency-rupee. In the case of derivatives involving only foreign currency, a
range of products such as Interest Rate Swaps, Forward Contracts and Options
are allowed. While these products can be used for a variety of purposes, the
fundamental requirement is the existence of an underlying exposure to foreign
exchange risk i.e. derivatives can be used for hedging purposes only. The RBI
has also formulated guidelines to simplify procedural/documentation
requirements for Small and Medium Enterprises (SME) sector. In order to
ensure that SMEs understand the risks of these products, only banks with
which they have credit relationship are allowed to offer such facilities. These
facilities should also have some relationship with the turnover of the entity.
Similarly, individuals have been permitted to hedge up to USD 100,000 on self
declaration basis. Authorized Dealer (AD) banks may also enter into forward
contracts with residents in respect of transactions denominated in foreign
currency but settled in Indian Rupees including hedging the currency indexed
exposure of importers in respect of customs duty payable on imports and price
risks on commodities with a few exceptions.
Domestic producers/users are allowed to hedge their price risk on aluminium,

copper, lead, nickel and zinc as well as aviation turbine fuel in international
commodity exchanges based on their underlying economic exposures.
Authorised dealers are permitted to use innovative products like cross-currency
options; interest rate swaps (IRS) and currency swaps, caps/collars and forward
rate agreements (FRAs) in the international foreign exchange market. Foreign
Institutional Investors (FII), person resident outside India having Foreign Direct
Investment (FDI) in India and Nonresident
Indians (NRI) are allowed access to the forwards market to the extent of their
exposure in the cash market.
A study on hedging instruments used by 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
2006-2007 Annual Reports of the respective companies. A summary of the
foreign exchange risk hedging behavior of select Indian firms is given in Tables
Currency
Instruments (mn) Rs (Cr) Nature of exposure
Reliance Industries
Currency Swaps 1064.49 Earnings in all businesses
are linked to USD. The key
Options Contracts 2939.76 input, crude oil is purchased
in USD. All exports
revenues are in foreign
currency and local prices
are based on import prices
Forward Contracts 5764.1 as well
as follows.
Table 1: Forex risk management at Reliance
Maruti Udyog
6411 (INR-JPY) Import/Royalty payable in Yen and
Forward Contracts 70 ($-INR) Exports Receivables in dollars.
Currency Swaps 124.70(USD -INR) Interest rate and forex risk.
Mahindra and Mahindra

Trade payables in Yen and Euro and
350 (INR-JPY)
export receivables in dollars.
2(INR-EUR)
Forward Contracts 27.3($-INR)
Currency Swaps 5390 (JPY-INR) Interest rate and forex risk.
Table 2: Forex risk management at Maruti
Arvind Mills

152.98 ($-INR) Most of the revenue is either
703.67 in dollars
2.25 (GBP-INR)
--- or linked to dollars due to
Forward Contracts 5 (INR-$) 21.88 export.
Option Contracts 1 2 2.5 ($-INR) 547.16
Table 3: Forex risk management at Mahindra & Mahindra
Infosys
119 ($- Revenues denominated in these
Forward Contracts INR) 529
currencies.
4 ($-INR) 18
Options Contracts
8 (INR-$) 36
Range barrier options 2 ($-INR) 971
3 (Eur-
INR)
Tata Consultancy Services
265.7
15 (Eur-INR) 5
Forward Contracts Revenues largely denominated in
21 (GBP-
INR) foreign currency, predominantly US$,
8 3 0 ($-INR) 4057 GBP, and Euro. Other currencie include
47.5 (Eur- Australian $, Canadian $, South African
Option Contracts INR)
Rand, and Swiss Franc
76.5 (GBP-
INR)
Table 4: Forex risk management at Arvind Mills
Ranbaxy
Exposed on accounts receivable and
Forward Contracts 2894.589 loans payable. Exposure in USD and
Jap Yen
Table 5: Forex risk management at Infosys and TCS

Dr. Reddy’s Labs
Forward Contracts 398 ($-INR) Foreign currency earnings through
11(Eur $) export, currency requirements for
settlement of liability for import of
Options Contracts 30 (EUR-$) goods.
Table 6: Forex risk management at Ranbaxy
Table 7: Forex risk management at Dr. Reddy’s Lab
Discussion on Hedging by Indian Firms
From Tables, 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 standardized 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
India11. 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. 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.
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
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
Rupee- Dollar 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
RBI’s 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 Committee on Fuller Capital Account Convertibility had recommended that

currency futures may be introduced subject to risks being contained through
proper trading mechanism, structure of contracts and regulatory environment.
Accordingly, Reserve Bank of India in the Annual Policy Statement for the Year
2007-08 proposed to set up a Working Group on Currency Futures to study the
international experience and suggest a suitable framework to implement the
proposal, in line with the current legal and regulatory framework. 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.

CALCULATION OF MARKET RISK USING VAR MODEL
The VaR is a number indicating the maximum amount of loss, with certain
specified confidence level, a financial position may incur due to some risk
events/factors, say, market swings (market risk) during a given future time
horizon (holding period).
It is important to note that any VaR number has two parameters, viz., holding
period (i.e. time horizon) and probability/confidence level. For a given portfolio,
VaR number changes with these two parameters - while VaR decreases
(increases) with the rise (fall) of probability level1, it changes in the same
direction with changes in holding period.
The choice of ‘probability/confidence level’ and ‘holding period’ would depend

on the purpose of estimating the VaR measure. It is now a common practice, as
also prescribed by the regulators, to compute VaR for probability level 0.01, i.e.
99% confidence level. In addition, researchers sometimes consider assessment
of risk for select other probability levels, such as, for probability 0.05.
DATA DESCRIPTION AND RESEARCH METHODOLOGY:
The primary objective of the study is to calculate Market Risk using the VaR
model and applying it on the real data of foreign exchange returns. To achieve
the objective last five-year (from 1 oct 2005 to 1 oct 2010) data of Foreign
Exchange Rates has taken and calculated the returns of the forex. By using all
VaR models Parametric, Non-parametric and Monte-Carlo Simulation on the
returns, calculated the market risk of one day and one month. Time horizon of
study was one day and one month and confidence level was 95%. Market Risk
is Risk occurs due to change in the market prices.
VAR TECHNIQUES:
-Historical Method (Non Parametric Method)
-Portfolio Normal Method (Parametric Method)
-Monte-Carlo Simulation
HISTORICAL METHOD:(Non Parametric Method)
The non-parametric approach, such as, historical simulation (HS), possess

some specific advantages over the normal method, as it is not model based,
although it is a statistical measure of potential loss. The main benefit is that it
can cope with all portfolios that are either linear or non-linear. The method
does not assume any specific form of the distribution of price change/return.
The method captures the characteristics of the price change distribution of the
portfolio, as it estimates VaR based on the distribution actually observed. But
one has to be careful in selecting past data. If the past data do not contain
highly volatile periods, then HS method would not be able to capture the same.
Hence, HS should be applied when one has very large data points to take into
account all possible cyclical events. HS method takes a portfolio at a point of
time and then revalues the same using the historical price series. Daily returns,
calculated based on the price series, are then sorted in an ascending order and
find out the required data point at desired percentiles. Linear interpolation can
be used to estimate required percentile if it falls in between two data points.
The process is simplified as follow:

• Calculate the return series of past price data of the security or the portfolio.
• Sort the returns in ascending order.
• In order to obtain VaR of the portfolio for probability ‘p’, 0<1, start from the
lowest return
and keep accumulating the weights until ‘p’ is reached. The return
corresponding with
accumulated weight ‘p’ relates to VaR. Linear interpolation may be used, if
necessary, to
attain exact ‘p’ of the distribution.
PARAMETRIC APPROACH:
This approach assumes that data (returns) are in normal distribution. In this
method we calculate the z score of the data at 95% confidence level. The VaR
given by,
VAR95% = Z95% (one tailed) * σdaily
Here σdaily is the standard deviation of the returns.
Value of Z at 95% confidence level is 1.65.
YEAR VAR- VAR- STD VARIANC MEAN

HISTORICA PARAMETRI DEVIATIO E
L APPROCH C N
APPROACH
2005-06 .3702 .3886 .2355 .0554 -.005
2006-07 .5945 .4892 .2965 .0879 -.015

2007-08 .4510 .6974 .4226 .1785 .063
2008-09 1.111 1.247 .7559 .5744 -.039
2009-10 1.269 1.219 .7335 .5380 .001
RESULTS OF VAR: (ONE DAY)
ANALYSIS:
We have calculated one day VaR at 95% confidence level in our calculation
using parametric approach and non-parametric approach for last five years of
foreign exchange rates. As we can see value of VaR is almost same by both the
methods. In 2005-06 the value of one day Var by using Historical and
parametric methods are .3702 and .5945 respectively. It means the maximum
loss that can occur in a single day is .37% and .59% in forex market. Similarly
in year 2006-07 the values of VaR is .5945 and .4892 and so on.
According to our calculation the maximum market risk occurred in year 2008-
09 and 2009-10. The values of VaR is in year 2008-09 are 1.111 and 1.247 it
means the maximum loss in one day are 1.111% and 1.247% in forex market
which is a huge amount. Similarly in year 2009-10 the values of VaR are 1.269
and 1.219, which is very high. Since the investments in the forex market has
been increasing over the time of period hence the volatility and risk are also
increasing. Similarly returns are also increasing.
As we can see from the table average returns of years. In years 2005-06, 2006-
07 and 2008-09 the mean returns are negative and in year 2007-08 and 2009-
10 the mean returns are positive. Hence we can say the market risk has
increased over the period of time.
FACTORS THAT INFLUENCES THE EXCHANGE RATES

Exchange Rate plays a vital role in a country’s level of trade, which is critical to
most every free market economy in the world. This is the reason foreign
exchange rate are among the most watched, analyzed and manipulated by
government for economic measurement. On a smaller scale the exchange rate
influences the investor’s portfolio as well.

Numerous factors determine exchange rates, and all are related to the trading
relationship between two countries. The following are some of the principal
determinants of the exchange rate between two countries.
Inflation Rate:
Inflation rate indicates the purchasing power of the investors. If the inflation
rate is very high it means liquidity in the market is more and the purchasing
power of the people is high, hence the will invest more in the foreign market.
By investing more in the forex maret the demand of the foreign currency will
increase and the foreign currency will appreciate and local currency will
depreciate. If the inflation rate is low then the results will be opposite, in that
case the local currency will appreciate due to high demand from the outside
investors and foreign currency will depreciate due to less demand.
Interest Rate:
Interest rate is one of the major factors affecting the foreign exchange rates. If
the interest is high of the country then investors will invest in the country with
high interest rate to get more returns it means the demand of the local
currency has increased and it will lead to appreciation of the currency. If the
interest decreases then the people will start borrowing the money from the
banks and their purchasing power will increase that will lead to high demand of
foreign currency and the local currency will decrease.
Current Account Deficit:
The current account is the balance of trade between a country and its trading
partners, reflecting all payments between countries for goods, services,
interest and dividends. A deficit in the current account shows the country is
spending more on foreign trade than it is earning, and that it is borrowing
capital from foreign sources to make up the deficit. In other words, the country
requires more foreign currency than it receives through sales of exports, and it
supplies more of its own currency than foreigners demand for its products. The
excess demand for foreign currency lowers the country's exchange rate until
domestic goods and services are cheap enough for foreigners, and foreign
assets are too expensive to generate sales for domestic interests.
Public Debt:
Countries will engage in large-scale deficit financing to pay for public sector
projects and governmental funding. While such activity stimulates the
domestic economy, nations with large public deficits and debts are less
attractive to foreign investors. The reason? A large debt encourages inflation,
and if inflation is high, the debt will be serviced and ultimately paid off with
cheaper real dollars.
In the worst-case scenario, a government may print money to pay part of a

large debt, but increasing the money supply inevitably causes inflation.
Moreover, if a government is not able to service its deficit through domestic
means (selling domestic bonds, increasing the money supply), then it must
increase the supply of securities for sale to foreigners, thereby lowering their

prices. Finally, a large debt may prove worrisome to foreigners if they believe
the country risks defaulting on its obligations. Foreigners will be less willing to
own securities denominated in that currency if the risk of default is great. For
this reason, the country's debt rating (as determined by Moody's or Standard &
Poor's, for example) is a crucial determinant of its exchange rate.
Political Stability and Economic Performance:
Foreign investors inevitably seek out stable countries with strong economic
performance in which to invest their capital. A country with such positive
attributes will draw investment funds away from other countries perceived to
have more political and economic risk. Political turmoil, for example, can cause
a loss of confidence in a currency and a movement of capital to the currencies
of more stable countries.
As we can see from the graph, in last 2 year the exchange rate has become
more volatile. The foreign investment has been increased drastically due to
more investment opportunity in India. There is significance change in the
foreign exchange rate in last two years.

LIVE CASE ON AN INDIAN S.M.E
Company Name: XYZ Ltd.
Company Overview:
XYZ Ltd. Is a textile exporting company comes under the purview of Small and
Medium Enterprises (S.M.E).
Key details of the Foreign Exchange Exposure/Risk faced by the company
A company may be exposed to foreign exchange fluctuations on two occasions,

the first being due to generation of revenues / expenses in various currencies
and second in the context of raising funds.
Being an exporter company, the foreign exchange currency exposure of arises

its products are exported across various countries. Hence bulk of its assets
comprises Sundry debtors having receivables in various currencies (USD).
Exposure in a simple export transaction
The transaction exposure typically arises following an export or import contract

subsequently giving rise to a foreign currency receivable or payable. On the
surface when the exchange rate changes, the value of the revenue or expense
in the domestic currency following these export or import transactions will be
affected in terms of the domestic currency. However when analyzed carefully,
it becomes apparent that the exchange risk results from a financial investment
(the foreign currency receivable) or a foreign currency liability (the loan from a
supplier) that is purely incidental to the underlying export or import
transaction.
For the financial year 2009-10, the company had had an approx figure of $80
million as the value of its currency receivable arising due to its exports. In the
past, to effectively manage its foreign exchange, the company has relied on a
set of financial instruments including forward contracts.
In an attempt to minimize the current risks that it runs on future cash flows in
anticipated receivables it approached HSBC Bank for buying a combination of
option contract to serve its purpose.
Client’s preferences and risk appetite:

The client wants a risk hedging strategy in place that will help him to ward off
the risk in a short span of time. Hence he wants a short span strategy that will
mitigate the current risk without having any future liabilities. He also wants to
gain maximum out of the structure that he intends to buy by reducing the
amount of premium payable. Thus he does not want to pay an upfront
premium. Such a hedging strategy will help him to reduce the volatility of its
future earnings, stabilize the cash flows and improve the forecasting of capital
budgeting projects.
The client is conservative in its risk management approach. He wants to use

the hedging approach to reduce it financial risk by having certainty in the flow
of payments.
Recommended Structure according to the Client’s need
The following is the structure presented to client for hedging “dollar

receivables”

Short term Hedging Structure
Spot Rate – Current $/Re rate: 40.17 (April 24, 2006)
View on Dollar/Rupee: Expect dollar to become stronger Vs rupee
· With surging global oil prices Re may depreciate further.
· Also reviving of dollar and outflows of foreign investment

from Indian stock market may lead to further depreciation of
Rupee.
Strategy
· Would suggest cover from only April to June right now.

Beyond that wait for better levels.
· For, April to June cover the notional in tranches
 Say book 30% forwards of it around 40.25-27

level
 For the balance 70% options
 However, this should be renewed on a

regular basis.
Reason for Such Strategy
In view of such volatile movement of Rupee, it is better to have

more of option cover (70%) and less of forward cover to be on a
safer side.
Options before Us:

The following are the different types of options available to the
client.

1) Buying an option (taking a long position)
Buy an option to sell $1million at 40.27 as strike rate
On Maturity
If S < given rate sell &1
million at the rate
S > given rate Sell

at market
· Cost of buying this option is 8 paisa i.e. you will pay Rs

80000 for every $1million to be covered
· Your worst case rate for selling dollars at the given rate.
You have all the upside above that.
· If spot goes above that rate you recover your option cost
as well.
3) Range Play
On maturity, if
S < 40.17 sell $1 million at
the lower rate 40.17 < S < 40.37

Rationale behind the proposed structure
· Make the Profit and Loss A/c less volatile.
· Avoid negative impact on future earnings due to extreme fluctuations in

the exchange rate of USD/INR.
· Improve Budgeting and forecasting techniques.
· By using options the client gets a range of options to choose from. Hence
giving him a high degree of flexibility to suit his risk appetite and manage
exposures.
· Options have been able to capture the upside with limited downside.
· Options have allowed the execution of various views such as directional

movement in spot rate as well as volatility of spot rate.
· The structure adopts a short term view on hedging.
Break of the structure into options and expected payoffs from the structure
under different circumstances of spot rate movements.
1. Single Forward
It is a simple forward contract wherein all uncertainties with respect to

the future exchange rate movement are removed by locking into a
prefixed strike rate irrespective of how the spot moves. The booked
forward rate is 40.25. Since the client wishes to sell dollars in exchange
of rupees and holds the view that dollar will become strong vs. Rupee, he
is locking in a rate to buy rupees so that he doesn’t lose so that he
doesn’t lose when rupee appreciates. Therefore he would gain of the spot
rate goes up than 40.25. Forward contract is an obligation thus it reduces
the flexibility of not exercising even if Dollar-INR is in favor for client i.e.
> 40.25 levels.
2. Buying an option
This type of an option is called long put where the buyer of the option
gets the right but not the obligation to sell the dollars at a specific
predetermined rate. The strike rate is 40.27. Thus on maturity the client
gains from the option if the spot rate moves below the given rate. Since
he will get 40.27 for every dollar sold. However in case of the spot
moving up from 40.27 the client will not exercise the option and sell at
the spot. He loses only the premium paid on the option. The break even
is 40.35 wherein the client recovers his Rs 80000 paid towards the
premium.
3. Range Play/Range forward
This option has been proposed with a view that in a range of spot rate
movement the client deals at the market rate whereas he wants to
protect his risk arising from extreme movement in currency rate. In the
range of 40.17-40.37 the client sells the dollar receivables at the spot or
market rate. He is willing to take the risk in rate movement in this range.
The client gains from the option if the spot rate falls below 40.17. The
spot option is worth for the counterparty buying dollars which is
exercised at spot above 40.37.
Keeping in view that the clients does not want to pay an upfront premium
also, the fact that over a short term 40.37 seems like a short resistance
to USD-INR.
INTERPRETATION OF THE STRUCTURE
The client being an exporter company is expecting levels in the dollar

rupee movement that will strengthen the dollar vis- a vis the rupee such
that when it sells its receivables(in$) it gains from such rupee
depreciation i.e. it gets more rupees for every dollar sold. Hence the
option contract that he intends to buy should offer him to sell dollars at
prefixed rates so that he doesn’t lose in value due to fluctuating
exchange rate movements.

Primary Research
PUBLIC
SECTOR
BANKS PRIVATE
STATE BANK FOREIGN
SECTOR
OF INDIA BANKS
PUNJAB BANKS ABN AMRO
NATIONAL KOTAK
STANDARD
BANK HDFC
ORIENTAL
CHARTERED
ICICI
BANK OF
COMMERCE
AXIS BANK
Private Bank
Name Kotak Bank
Contact Person Mr. Vishal Sharma
Business Banking Manager, deals in all
Profile trading business
15-20 days within which the credit
team ascertains the creditworthiness
Time required for booking of the customer

Past 3 year Financial Statements,
Indemnity letter, thereafter the
sanction letter is obtained from the
Documents required Head Office
Minimum Contract Size Not specific
Cash Back Lending required or

Provide limits to Clients
Is Dealing room in Delhi (Y/N) N
Where else located? Mumbai
Provide Advisory Services (Y/N) Y
CHARGES
Rs 1000 as one time charge + Rs 112
Booking- whenever customer receives payment
Rs 1000 + The loss incurred in the
differential amount due to currency
Cancellation- fluctuations
Depends on client relationship and the
volumes traded; Completely
Margin % negotiable
Other Service (Y/N) N
Online Portal N
Sms Fx N
Aggressive Marketing (Y/N) N
Findings:
Private Bank
Name ICICI Bank
Contact Person Mr. Anand Singla
If have current account,
then 7-8 Days; if not then
Time required for booking 12 days
Documents required
Cash back lending; On the
basis of trade volume the
Cash Back Lending required bank provides forward
or Provide limits to Clients limits
Is Dealing room in Delhi (Y/N) No assistance provided
Where else located? Mumbai
Provide Advisory Services
(Y/N) Y
CHARGES
Booking- Rs 1000
Cancellation- Rs 1000
7-10%; going to be raised
Margin Money % to 20-25% by Co. policy

Margin is not fixed; Varies
Is this margin fixed or as per client relationship
changes tenure wise and trading volume size
Margin/Spread 5 p on USD; 7 p on Euro
Other Service (Y/N) Y
Online Portal Y
Sms Fx Y
Aggressive Marketing (Y/N) Y
Card rates as on 09 April TT TT

2009 in BUYING SELLING
GBP 72.89 74.23
USD 49.75 50.21
SWISS FRANC (CHF) 43.12 43.93
YEN (JPY) 0.4968 0.5059
EUR 65.7 66.91
Private Sector Banks

3.Name: HDFC Bank
Contact Person- Mr.Ashwini Gupta

Profile- Bank Manager
Time req.for booking 5-6 days
Documents req. 1.Request Letter
What is Minimum Contract Size Not specific
Create a Fixed Deposit
of 25 % on the amount
being booked;this
Cash Back Lending Req. or Provide margin money % is
limits to Clients variable
Is Dealing room in Delhi(Y/N) N

Where else located ? Gurgaon/Bombay
Provide Advisory Services?(Y/N) Y
CHARGES
Booking- 0
Cancellation- 0
variable depending on
Margin % client relationship
Is this margin fixed or changes

tenurewise Changes Tenurewise
Other Service (Y/N)

Online Portal
Sms Fx
Aggressive Marketing(Y/N) Y
TT TT
BUYING SELLING
What are your card rates as of ( 9

Apr,09 ) in.. GBP 72.3 75.14
USD 49.2 50.98
SWISS FRANC(CHF) 42.97 44.14
YEN( JPY) 0.4939 0.5093
EUR 65.49 67.25

Foreign Bank
Name
Contact Person Rohin Puri
Profile Wealth Manager
Time required for
booking 2 Days
Minimum Contract Size USD 40000
Cash Back Lending / take
FD which depends on
Cash Back Lending tenure and currency for
required or Provide which forward contract is to
limits to Clients be booked.
Dealing room in Delhi
(Y/N) Yes
Provide Advisory
Services (Y/N) Yes
CHARGES
Booking- 500
Cancellation- 500
Is this margin fixed or
changes tenure wise It is fixed
Online Portal N
Sms Fx N
Aggressive Marketing
(Y/N) Yes
Generally variable
depending on client
relations ,charged as per
Margin card rates
Eg: For 30000 USD for a 10-15 p on IBR as per
month currency fluctuation
TT
TT SELLIN
Card rates as on in BUYING G
GBP 73 75.9
USD 49.25 50.75
YEN (JPY) 0.496 0.521
EUR 64.6 68

PROPOSED
MARGINS
PSU
Name State Bank of India
Contact Person Mr. Ashok Singh
Profile
Time required for booking Instant
Documents required
Variable depending on
Minimum Contract Size client transaction rate
Provide limits by
assessing the
creditworthiness;
Demand FD when doubt
Cash Back Lending required or the credit standing of
Provide limits to Clients the customer
Dealing room in Delhi (Y/N) Y
Where else located? Bombay
When asked by the
client; By self even to
Provide Advisory Services big ticket customers
(Y/N) who request for it

CHARGES
Rs. 750 + Expenses
levied per transaction
varies depending on the
Booking- amount being traded
Cancellation- Rs. 700
Variable depending on
Margin % client relationship
tenure wise Variable
The customer can
directly book through
the centralized Treasury
without intervening with
Other Service (Y/N) the branch
Online Portal N
Sms Fx N
Aggressive Marketing (Y/N)
TT TT
BUYING SELLING
Card rates as on 02 April 2009
in USD 49.88 50.8
YEN (JPY) 50.32 51.67
EUR 65.97 67.69
PSU
Name Punjab National Bank
Contact Person Mr.D.K.Agarwal
Profile Forex Dealer
Request letter; Past 3
Documents required year financials
Cash Back Lending required or No cash back lending

Provide limits to Clients but provide limits
Where else located Mumbai
Provide Advisory Services (Y/N) On Demand
CHARGES
Booking- Rs 1000
For Early Delivery+ Extension
of contract Rs 700+ Swap cost
Cancellation- Nil
Margin % Is variable
Does your expenses vary as per
currency Y
tenure wise N
TT
TT SELLIN
Aggressive Marketing (Y/N) BUYING G
Card rates as on 15 Apr, 2009 in GBP 73.99 74.7

USD 49.83 50.17
YEN (JPY) 50.53 51.22
EUR 65.71 66.84

PSU
Oriental Bank of
Name Commerce
Contact Person Mr. Singh / Mr. Pravin
Senior Forex
Profile Manager / Treasury
Request letter; Past 3
Documents required year financials
Cash Back Lending required No cash back lending
or Provide limits to Clients but provide limits
Provide Advisory Services
(Y/N) N
CHARGES
Booking- Rs 500
Cancellation- Nil
for eg:
Anythin
for eg: g of
Ambika $2500
traders, one or
of the most equival
elite ent
customers charge
charged 2p d aprox
Variable depending on for Dollar and 10-15
Margin % client relationship 5p for Euro paise
Is this margin fixed or Is variable, not tenure

changes tenure wise wise
Aggressive Marketing (Y/N) N
TT
SELLIN
TT BUYING G
Card rates as on 27 Mar
2009 in GBP 72.96 73.37
USD 50.42 50.71
YEN (JPY) 51.06 51.73
EUR 68.3 68.91

Booking
Charges
HSB Kota
C OBC SBI k ICICI PNB ABN
Amount (in
Rs.) 500 500 750 1000 1000 1000 500
INTERPRETATION
So far we analyze that as per the data collected private banks charge
most for booking of forwards whereas the Public sector, OBC, PNB and SBI
also differ in the booking charges .With PNB charging the highest in the
PSU sector. This shows that banks belonging to one sector also differ in
their product offerings. With highest booking charges levied by Kotak,
ICICI and PNB
Cancellation
Charges
HSB Kota
C OBC SBI k ICICI PNB ABN
Amount (in
Rs.) 500 0 700 1000 1000 0 500

Forex Srikant

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“Unveiling Foreign Exchange Market

Exposure Modeling and Forex Risk

Under the Guidance of

FOREIGN EXCHANGE MARKET

1. Name of the Candidate: SRIKANT SHARMA Roll No.:

2. Topic:Unveiling Foreign Exchange Market

3. Name of the Guide: Prof. DEEPAK TANDON

SIGNATURE OF THE GUIDE

FOREIGN EXCHANGE MARKET

Firstly, I express my sincere thanks to my immediate guide, Prof. Deepak Tandon,

FOREIGN EXCHANGE MARKET

FOREIGN EXCHANGE MARKET

Introduction of Forex Market

Hedging as a tool to manage

FOREIGN EXCHANGE MARKET

Factors Influencing the Foreign Exchange

Analysis of Foreign Exchange Rates…………………………………………………………

FOREIGN EXCHANGE MARKET

 To understand and analysis of Current India Forex Market.

 To study the major participants of Forex Market.

 To carry out primary research for data collection.

 To understand the product offering of the other banks.

 To find the Risks associated with the Forex Market.

 To calculate the Market Risk using VaR Technique.

 To understand the Forex Risk Management.

o Design a Hedging strategy

o Basics Hedging Techniques

o To Hedge or not to hedge

2. Calculation of Market Risk associated with Forex using VaR Model.

FOREIGN EXCHANGE MARKET

4. Primary data shall be collected and interpolated with the help of

Foreign Exchange Market is an inter-bank market that took shape in 1971

Commercial companies play an important role in the forex market. They do

FOREIGN EXCHANGE MARKET

Another class of market participants involved with foreign exchange-related

RETAIL FOREIGN EXCHANGE BROKER:

ATTRACTIVE FEATURES OF THE MARKET

Promptness: With a 24-hour work schedule, participants in the FOREX market

Availability: A possibility to trade round-the-clock; a market participant need

Flexible regulation of the trade arrangement system: A position may be opened

MARGIN TRADING SYSTEM

FOREIGN EXCHANGE MARKET

As mentioned above, unlike with forex transactions with actual delivery or

FOREIGN EXCHANGE MARKET

ANALYZING FOREX MARKET

USD 1.00 = INR 44.50 [Direct Quote for US dollar in India]

Indirect Exchange Rates:

The exchange rate is quoted in terms of the number of units of foreign

USD2.3529 = INR 100 [Indirect quotation in India for the US dollar]

In an indirect quotation, the home currency is the commodity (denominator)

In India, all quotations are now in terms of Direct Rates

European terms convention – Almost all exchange rates are expressed as

The yen exchange rate is 154.20/30

The dealer buys a dollar for 154.20 yen

The dealer sells a dollar for 154.30 yen

A point is .01 yen; the spread is .10 yen (10 points)

FOREIGN EXCHANGE MARKET

What Rate Would You Purchase At?

As a market maker the bank buys INR and Sells HKD

1 INR =0.169 HKD

So Bank will buy 1 INR and sell HKD @ 0.169.

TT buying- Rate at which a Foreign Inward Remittance received by telegraphic