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Forex Risk Management


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FOREX RISK MANAGEMENT (As partial fulfillment for the award of MBA degree under University of Allahabad)







NARINDER KUMAR BHASIN Vice President Branch Head MONIRBA Summer Internship 2011 2



Dharmendra kumar chaurasia,





hereby declare that the project work titled- ‘‘Forex Risk Management” was carried out by me at AXIS BANK,


in partial fulfillment of the degree Master in Business Administration,

is the original work conducted by me

This programme was undertaken as a part of academic curriculum according to the University rules and norms and by no commercial interest and motives

The information and data given in the report is authentic to the best of my Knowledge


Dharmendra kumar chaurasia MBA 3rd semester MONIRBA Summer Internship 2011 3



I would like to express my gratitude to ‘AXIS BANK’ which provided me a platform to experience financial strategy first hand out in the field

The experience I gained and the relations I have made in the bank through this am bound less

For turning this project to perfection,

I’d like to specially thank our project head Dr

Narinder Kumar Bhasin (Branch Head) and Ms

Geetu Seth (Manager-Forex) for their unbound support

The work would not have been possible to come to the present shape without the able guidance,

Using their expertise was my road to success

I express my sincere gratitude to Prof

Singhal (INCHARGETraining and placement division Motilal Nehru Institute of Research and Business Administration for providing me an opportunity to undergo summer training at AXIS BANK

I am also thankful to Mr

Ashish Awasthi (Manager Treasury) for her support,

and motivation provided to me during the training for constant inspiration,

I would like to thank the Motilal Nehru Institute of Research And Business Administration,

for providing the opportunity to work with Axis Bank


with deep sense of gratitude I acknowledged the encouragement and guidance received by who helped and supported me during the course,

for completion of my project report

Dharmendra kumar chaurasia MONIRBA Summer Internship 2011 4























MONIRBA Summer Internship 2011 5

RESEARCH OBJECTIVES  To study the Indian Forex  To study the Risk involved in currency trading  To identify the areas for compensating Risk in Forex  The tools and techniques for minimizing risk in forex  The tools and techniques for minimizing risk in forex

MONIRBA Summer Internship 2011 6


MONIRBA Summer Internship 2011 7

The Indian Banking Environment Modern banking in India started in the early 18th century1

banks are among the main participants of the financial system in India

BANKING STRUCTURE The commercial banking structure in India consists of: Scheduled Commercial Banks & Unscheduled Banks,

with the Reserve Bank of India (RBI) as the apex governing body

RBI has licensing powers & the authority to conduct inspections on other banks

The chart below depicts the Indian banking industry

The figures in brackets are the number of banks in each category

RESERVE BANK OF INDIA Central Bank and supreme monetary authority

Non-Scheduled Banks

Scheduled Banks

Urban Cooperatives

Local Areas Banks (4)



Rural Cooperatives

Nationalized Banks (19)

Public Sector

SBI & Associates (7)

Private Sector (22)

Regional Rural Banks (82)

MONIRBA Summer Internship 2011 8

Foreign Banks (31)

RBI is the apex governing body in the Indian Banking industry

It formulates guidelines from time to time to ensure a clean banking environment

It is responsible for overseeing the activities of other banks

It issues licenses to other banks to start new branches,

It also conducts regular checks to ensure that all guidelines are being adhered to

It is responsible for controlling the money supply in the economy

Non-Scheduled Banks These are banks,

which are not included in the Second Schedule of the Reserve Bank of India Act,

as they do not satisfy the conditions laid down by that schedule

Scheduled Banks Scheduled Banks are those,

which are included in the Second Schedule of the Reserve Bank of India Act,

Looking at the snippet on the right,

it is apparent that all big banks are scheduled banks

They can be classified further as Commercial Banks and Cooperative Banks

Cooperative Banks A non commercial bank registered under the State Co-Operative Societies Act or the Multi State cooperative Societies Act

Commercial Banks  Foreign Banks: These are banks that were incorporated outside India but have branches

For example,

ABN Amro,

BNP Paribas,

 Public Sector Banks: Banks in which the government has got majority shareholdings are

This group consists of SBI and its Associates,

Regional Rural Banks,

 State Bank of India and its Associates: This group comprises of the State Bank of India

(SBI) and its six Associates

MONIRBA Summer Internship 2011 9

Regional Rural Banks: These banks were established as per the provisions of the Regional Rural Banks Act,

A Regional Rural Bank is a joint ownership between the Central Government,

the State Government and a sponsoring bank in the ratio 50:15:35

RRBs were established to operate exclusively in rural areas to provide credit and other facilities to small and marginal farmer,

artisans and small entrepreneurs

 Nationalized Banks: This group consists of erstwhile private sector banks that were

brought under government control

The Government of India Nationalised 14 private banks in 1969 and another 6 in the year 1980,

New Bank of India was merged with Punjab National Bank

 Old Private Sector Banks: This group consists of banks that were established by the privy

community organizations or by a group of professionals for the cause of economic betterment in their areas of operation

Initially their operations were concentrated in a few regional areas


their branches slowly spread throughout the nation as they grew

These Banks are registered as companies under the Companies Act 1956 and were incorporated prior to 1994

 New Private Sector banks: RBI permitted formation of new private sector Banks after

accepting the recommendations of Narasimham Committee with an objective to bring more competition and efficiency in the banking sector

These banks were started as profit oriented public limited companies

These banks are technology-driven and thus usually better managed than other banks

Axis Bank is among the first banks to start operations as a new generation Private sector bank

New Private Sector Banks came into existence after 1994

MONIRBA Summer Internship 2011 10

Axis Bank was the first of the new private banks to have begun operations in 1994,

after the Government of India allowed new private banks to be established

The Bank was promoted jointly by the Administrator of the Specified Undertaking of the Unit Trust of India (SUUTI),

Life Insurance Corporation of India (LIC),

General Insurance Corporation of India (GIC) and the four PSU General Insurance companies,

National Insurance Company Ltd

The New India Assurance Company Ltd

The Oriental Insurance Company Ltd

and United India Insurance Company Ltd

The present shareholding pattern of our Bank is as given below

Administrator of the Specified

Undertaking of the UTI Life Insurance Corporation of India GIC and four PSU Insurance Companies Non-Promoter Indian Shareholding Non-Promoter Foreign Shareholding

Our Board of Directors MONIRBA Summer Internship 2011 11

Dr Adarsh Kishore Smt

Shikha Sharma

Chairman Managing Director & CEO

Shri Sisir K Chakrabarti

Deputy Managing Director

Varma Dr

Patil Smt

Rama Bijapurkar

Director Director Director

Vaish Shri M

Subbiah Shri K


Director Director Director



Shri S B Mathur Shri M S Sundara Rajan

Director Director

S K Roongta


Prasad R Menon


Axis Bank Vision and Mission 2015 MONIRBA Summer Internship 2011 12

Core Value of Axis Bank MONIRBA Summer Internship 2011 13

Customer Centricity Understand customer’s needs to offer suitable solutions in timely and courteous manner to ensure lifetime customer relationship

Guiding principle:  Treat customers with respect and courtesy

 Proactively reach out to the customer to understand their needs and offer solutions

 Always deliver to the promise

 Work to words achieving customer loyalty

Ethics Ensure fairness,

honesty and integrity in our intent and practices at all times

Guiding principle:  Practice Axis code of conduct in spirit

 Be fair and respectful to all

 Maintain individual integrity  Encourage ethical behavior at all times

Transparency Follow open and fair exchange of communication at all time

Guiding principal:  Ongoing sharing of knowledge and information

 Ensure common understanding of information and facts

 Encourage open and fair practices

 Share appropriate and accurate information on a timely basis with underlying principles

( not only ‘what’ but also how and why )

MONIRBA Summer Internship 2011 14

Teamwork Promote a culture of trust and honesty and align collective ideas,

skills and resources to continuously deliver excellence at all times

Guiding principal:  Support a culture of mutual respect,

 Align collective strengths and go out of the way to achieve the goal of the bank

 Be on active team player and make quality contributions to the team effort

 Openly communicate and support each other

Ownership Continually work in the best interest of the nurturing a sense of belonging and by accepting responsibility for individual and collective action

Guiding principal:  Inspire a sense of belonging

 Take responsibility for joint out come

 Partner in organizational success and excellence

 Encourage responsibility and accountability for all actions and outcome

MONIRBA Summer Internship 2011 15

Axis Bank Highlights Business Figures as on 30th September,

Advances: Rs

Current Accounts: Rs

Net Profit: Rs

ATMs : 4,846 (4,293) International Presence: 4 Centres,

Capital Adequacy Ratio: 13

Branches at

18) % ]


Hong Kong and Dubai,

and Representative Offices in Shanghai and Dubai

Equity Capital : Rs

Leadership positions: MONIRBA Summer Internship 2011 16

 First Indian Bank to launch Travel Currency Cards,

now in 9 currencies  First Indian bank to launch Remittance Card and Meal Card

 Over 169,000 EDC machines – Second largest in the cards acquiring business in India  6,778 CMS clients – Among the top players

Debt Capital Markets  Ranked No

Recent Awards:

Asia Money 2010: Best Domestic Debt House in India

Euromoney 2010: Best Debt House in India

Finance Asia 2010: Best Bond House in India


36 crore)

Consistent track record of profitability

Net profit increased by more than 30% y-o-y in the past 40 out of 42 quarters

Asset Quality: ▫ Net NPA

MONIRBA Summer Internship 2011 17


the business divisions in the bank leaving aside the support functions are as follows:  Retail Banking,

SME & Agri  Corporate Banking and Institutional Banking

Retail Banking,

SME and Agri Consists of four segments  Mass and Mass Affluent segment

The group manages the retail liability,

retail asset and card products of the Bank

MONIRBA Summer Internship 2011 18

 Affluent segment : The group manages all the affluent customer segments such as Wealth Management and Private Banking,

all investment products (Insurance,

GOD etc)  Distribution: The group manages the overall distribution infrastructure for the Bank’s

 Advances : The group manages the SME and Agri business of the Bank

Corporate & Institutional Banking Consists of seven segments  Infrastructure: Provides end to end services including credit,

and other corporate banking services to infrastructure companies

 Large Corporate: Provides end to end services for Large corporates including the

international banking business

 Mid Corporate: Provides end to end services for Mid corporates

 Capital Markets: Provides advisory services Mergers and Acquisitions,

Private Equity

syndication and Equity Capital Markets including broker financing and other stock market related activities

 Business Banking: Provides various services to Corporate,

Government and Business

Banking clients including current accounts,

They are also responsible for Custodial services and Corporate Depository services

 Treasury: Treasury is responsible for the maintenance of the statutory requirements such

as the Cash Reserve Ratio (CRR),

Statutory Liquidity Ratio (SLR) and the investment of such funds

It also manages the assets and liabilities of the bank

Primary Dealing activities can be classified into Money Market Operations,

Foreign Exchange Operations,

Currency Futures,

International Business,

CSGL facilities,

Derivatives etc  DCM and Equity trading: Primarily deals with DCM origination,

trading activities of the Bank

MONIRBA Summer Internship 2011 19


also referred to as the "Forex" or "FX" market is the largest financial market in the world,

with a daily average turnover of US$1

equity markets and the daily average turnover in foreign exchange market in India declined around 30 per cent to $27


the daily average turnover in USD/INR pair in 2010 is higher at $36 billion

Since not all the trading in foreign exchange market in India is in USD/INR pair alone,

it can be assumed that more than 23 per cent of the trading in the USD/INR pair takes place overseas

Market share of 23 emerging market currencies increased to 14 per cent in April 2010 from 12

Largest increases in emerging market currencies were in Turkish lira,

Korean won,

Brazilian real and Singapore dollar

"Foreign Exchange" is the simultaneous buying of one currency and selling of another

Currencies are traded in pairs,

for example Euro/US Dollar (EUR/USD) or US Dollar/Japanese Yen (USD/JPY)

MONIRBA Summer Internship 2011 20

Source: BIS Triennial Survey 2010

Source: BIS Triennial Survey 2010

MONIRBA Summer Internship 2011 21

There are two reasons to buy and sell currencies

About 5% of daily turnover is from companies and governments that buy or sell products and services in a foreign country or must convert profits made in foreign currencies into their domestic currency

The other 95% is trading for profit,

For speculators,

the best trading opportunities are with the most commonly traded (and therefore most liquid) currencies,

more than 85% of all daily transactions involve trading of the Majors,

Japanese Yen,

British Pound,

Swiss Franc,

Canadian Dollar and Australian Dollar

A true 24-hour market,

Forex trading begins each day in Sydney,

and moves around the globe as the business day begins in each financial center,


Unlike any other financial market,

investors can respond to currency fluctuations caused by economic,

social and political events at the time they occur

The FX market is considered an Over the Counter (OTC) or 'interbank' market,

due to the fact that transactions are conducted between two counterparts over the telephone or via an electronic network

Trading is not centralized on an exchange,

as with the stock and futures markets

MONIRBA Summer Internship 2011 22

LITERATURE REVIEW Functions of Foreign Exchange Market The foreign exchange market is a market in which foreign exchange transactions take place

In other words,

it is a market in which national currencies are bought and sold against one another

A foreign exchange market performs three important functions: ⇒ Transfer of Purchasing Power:

The primary function of a foreign exchange market is the transfer of purchasing power from one country to another and from one currency to another

The international clearing function performed by foreign exchange markets plays a very important role in facilitating international trade and capital movements

The credit function performed by foreign exchange markets also plays a very important role in the growth of foreign trade,

for international trade depends to a great extent on credit facilities

Exporters may get pre-shipment and post-shipment credit

Credit facilities are available also for importers

The Euro-dollar market has emerged as a major international credit market

⇒ Provision of Hedging Facilities:

The other important function of the foreign exchange market is to provide hedging facilities

Hedging refers to covering of export risks,

and it provides a mechanism to exporters and importers to guard themselves against losses arising from fluctuations in exchange rates

Advantages of Forex Market Although the forex market is by far the largest and most liquid in the world,

day traders have up to now focus on seeking profits in mainly stock and futures markets

This is mainly due to the MONIRBA Summer Internship 2011 23

restrictive nature of bank-offered forex trading services

Advanced Currency Markets (ACM) offers both online and traditional phone forex-trading services to the small investor with minimum account opening values starting at 5000 USD

There are many advantages to trading spot foreign exchange as opposed to trading stocks and futures

Below are listed those main advantages

⇒ Commissions: ACM offers foreign exchange trading commission free

This is in sharp contrast to (once again) what stock and futures brokers offer

A stock trade can cost anywhere between USD 5 and 30 per trade with online brokers and typically up to USD 150 with full service brokers

Futures brokers can charge commissions anywhere between USD 10 and 30 on a round turn basis

⇒ Margins requirements: ACM offers a foreign exchange trading with a 1% margin

In layman's terms that means a trader can control a position of a value of USD 1'000'000 with a mere USD 10'000 in his account

By comparison,

futures margins are not only constantly changing but are also often quite sizeable

Stocks are generally traded on a non-margined basis and when they are,

it can be as restrictive as 50% or so

⇒ 24 hour market: Foreign exchange market trading occurs over a 24 hour period picking up in Asia around 24:00 CET Sunday evening and coming to an end in the United States on Friday around 23:00 CET

Although ECNs (electronic communications networks) exist for stock markets and futures markets (like Globex) that supply after hours trading,

liquidity is often low and prices offered can often be uncompetitive

⇒ No Limit up / limit down: Futures markets contain certain constraints that limit the number and type of transactions a trader can make under certain price conditions

When the price of a certain currency rises or

MONIRBA Summer Internship 2011 24

falls beyond a certain pre-determined daily level traders are restricted from initiating new positions and are limited only to liquidating existing positions if they so desire

This mechanism is meant to control daily price volatility but in effect since the futures currency market follows the spot market anyway,

the following day the futures market may undergo what is called a 'gap' or in other words the futures price will re-adjust to the spot price the next day

In the OTC market no such trading constraints exist permitting the trader to truly implement his trading strategy to the fullest extent

Since a trader can protect his position from large unexpected price movements with stop-loss orders the high volatility in the spot market can be fully controlled

⇒ Sell before you buy: Equity brokers offer very restrictive short-selling margin requirements to customers

This means that a customer does not possess the liquidity to be able to sell stock before he buys it

Margin wise,

a trader has exactly the same capacity when initiating a selling or buying position in the spot market

In spot trading when you're selling one currency,

you're necessarily buying another

MONIRBA Summer Internship 2011 25



Bank and money changers


Bank account or deposits


Central Bank

(Through brokers)



(Outright & Swaps)


Non-merchandise Merchandise


MONIRBA Summer Internship 2011 26

Main Participants In Foreign Exchange Markets There are four levels of participants in the foreign exchange market

At the first level are tourists,

These are the immediate users and suppliers of foreign currencies

At the second level are the commercial banks,

which act as clearing houses between users and earners of foreign exchange

At the third level are foreign exchange brokers through whom the nation’s commercial banks even out their foreign exchange inflows and outflows among themselves

Finally at the fourth and the highest level is the nation’s central bank,

which acts as the lender or buyer of last resort when the nation’s total foreign exchange earnings and expenditure are unequal

The central then either draws down its foreign reserves or adds to them

PARTICIPANTS CUSTOMERS The customers who are engaged in foreign trade participate in foreign exchange markets by availing of the services of banks

Exporters require converting the dollars into rupee and importers require converting rupee into the dollars as they have to pay in dollars for the goods / services they have imported

Similar types of services may be required for setting any international obligation i

payment of technical know-how fees or repayment of foreign debt,

COMMERCIAL BANKS They are most active players in the forex market

Commercial banks dealing with international transactions offer services for conversation of one currency into another

These banks are specialised in international trade and other transactions

They have wide network of branches


commercial banks act as intermediary between exporter and importer who are situated in different countries

This action of bank may trigger a spate of buying and selling of MONIRBA Summer Internship 2011 27

foreign exchange in the market

Commercial banks have following objectives for being active in the foreign exchange market:  They render better service by offering competitive rates to their customers engaged in international trade

 They are in a better position to manage risks arising out of exchange rate fluctuations

 Foreign exchange business is a profitable activity and thus such banks are in a position to generate more profits for themselves

 They can manage their integrated treasury in a more efficient manner

CENTRAL BANKS In most of the countries central banks have been charged with the responsibility of maintaining the external value of the domestic currency

If the country is following a fixed exchange rate system,

the central bank has to take necessary steps to maintain the parity,

Even under floating exchange rate system,

the central bank has to ensure orderliness in the movement of exchange rates

Generally this is achieved by the intervention of the bank

Sometimes this becomes a concerted effort of central banks of more than one country

Apart from this central banks deal in the foreign exchange market for the following purposes:  Exchange rate management:

Though sometimes this is achieved through intervention,

yet where a central bank is required to maintain external rate of domestic currency at a level or in a band so fixed,

they deal in the market to achieve the desired objective

Central bank of the country is mainly concerned with the investment of the countries foreign exchange reserve in a stable proportion in range of currencies and in a range of assets in each currency

These proportions are,

influenced by the structure of official external assets/liabilities

For this bank has involved certain amount of switching between currencies

MONIRBA Summer Internship 2011 28

Central banks are conservative in their approach and they do not deal in foreign exchange markets for making profits


there have been some aggressive central banks but market has punished them very badly for their adventurism

In the recent past Malaysian Central bank,

Bank Negara lost billions of dollars in foreign exchange transactions

 Intervention by Central Bank It is truly said that foreign exchange is as good as any other commodity

If a country is following floating rate system and there are no controls on capital transfers,

then the exchange rate will be influenced by the economic law of demand and supply

If supply of foreign exchange is more than demand during a particular period then the foreign exchange will become cheaper

On the contrary,

if the supply is less than the demand during the particular period then the foreign exchange will become costlier

The exporters of goods and services mainly supply foreign exchange to the market

If there are no control over foreign investors are also suppliers of foreign exchange

During a particular period if demand for foreign exchange increases than the supply,

it will raise the price of foreign exchange,

in terms of domestic currency,

This will no doubt make the imports costlier and thus protect the domestic industry but this also gives boost to the exports


in the short run it can disturb the equilibrium and orderliness of the foreign exchange markets

The central bank will then step forward to supply foreign exchange to meet the demand for the same

This will smoothen the market

The central bank achieves this by selling the foreign exchange and buying or absorbing domestic currency

Thus demand for domestic currency which,

coupled with supply of foreign exchange,

will maintain the price of foreign currency at desired level

This is called ‘intervention by central bank’

If a country,

follows fixed exchange rate system,

the central bank is required to maintain exchange rate generally within a well-defined narrow band

Whenever the value of the domestic currency approaches upper or lower limit of such a band,

the central bank intervenes to counteract the forces of demand and supply through intervention

In India,

the central bank of the country,

has been enjoined upon to maintain the external value of rupee

Until March 1,

under section 40 of the Reserve Bank MONIRBA Summer Internship 2011 29

Reserve Bank was obliged to buy from and sell to authorised persons i

AD’s foreign exchange


under Modified Liberalised Exchange Rate Management System (Modified LERMS),

Reserve Bank is not obliged to sell foreign exchange

it will purchase foreign exchange at market rates

with a view to maintain external value of rupee,

Reserve Bank has given the right to intervene in the foreign exchange markets

EXCHANGE BROKERS Forex brokers play a very important role in the foreign exchange markets

However the extent to which services of forex brokers are utilized depends on the tradition and practice prevailing at a particular forex market centre

In India dealing is done in interbank market through forex brokers

In India as per FEDAI guidelines the AD’s are free to deal directly among themselves without going through brokers

The forex brokers are not allowed to deal on their own account all over the world and also in India

In India broker’s commission is fixed by FEDAI

SPECULATORS Speculators play a very active role in the foreign exchange markets

In fact major chunk of the foreign exchange dealings in forex markets in on account of speculators and speculative activities

The speculators are the major players in the forex markets

Banks dealing are the major speculators in the forex markets with a view to make profit on account of favourable movement in exchange rate,

if they feel the rate of particular currency is likely to go up in short term

They buy that currency and sell it as soon as they are able to make a quick profit

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Corporations particularly Multinational Corporations and Transnational Corporations having business operations beyond their national frontiers and on account of their cash flows

Being large and in multi-currencies get into foreign exchange exposures

With a view to take advantage of foreign rate movement in their favour they either delay covering exposures or does not cover until cash flow materialize

Governments narrow or invest in foreign securities and delay coverage of the exposure on account of such deals

Individual like share dealings also undertake the activity of buying and selling of foreign exchange for booking short-term profits

They also buy foreign currency stocks,

bonds and other assets without covering the foreign exchange exposure risk

This also results in speculations

Corporate entities take positions in commodities whose prices are expressed in foreign currency

This also adds to speculative activity

The speculators or traders in the forex market cause significant swings in foreign exchange rates

These swings,

do not do any good either to the national or international trade and can be detrimental not only to national economy but global business also


they provide the much need liquidity and depth to foreign exchange markets

This is necessary to keep bid-offer which spreads to the minimum


liquidity also helps in executing large or unique orders without causing any ripples in the foreign exchange markets

One of the views held is that speculative activity provides much needed efficiency to foreign exchange markets

Therefore we can say that speculation is necessary evil in forex markets

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The Forex market is open 24 hours a day,

Limited floor trading hours dictated by the

Because of the decentralised time zone of the trading location,

significantly clearing of trades and overlap of major markets restricting the number of hours a market is open in Asia,

London and the United States,

the and when it can be accessed

market remains open and liquid throughout the day and overnight

Most liquid market in the world eclipsing all Threat of liquidity drying up after market hours others in comparison

Most transactions must or because many market participants decide to continue,

since currency exchange is a required stay on the sidelines or move to more popular mechanism


Traders are gouged with fees,

exchange fees and government fees

One consistent margin rate 24 hours a day Large capital requirements,

allows Forex traders to leverage their capital restrictions on shorting,

more efficiently with as high as 100-to-1 leverage

No Restrictions

Short selling and stop order restrictions

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FOREIGN EXCHANGE Meaning of Foreign Exchange: Sec

It includes the following four items: i

Foreign Exchange primarily means “foreign currency”

It also means Deposits,

Credits and balance payable in foreign currency

It also means Draft/trevellers cheque/ Letter of credit/ Bill of exchange drawn in foreign currency by banks outside India

Lastly it also means Draft/trevellers cheque/ Letter of credit/ Bill of exchange expressed in rupees but payable in foreign currency

Fixed and Floating Exchange Rates In a fixed exchange rate system,

the government (or the central bank acting on the government's behalf) intervenes in the currency market so that the exchange rate stays close to an exchange rate target

When Britain joined the European Exchange Rate Mechanism in October 1990,

we fixed sterling against other European currencies Since autumn 1992,

Britain has adopted a floating exchange rate system

The Bank of England does not actively intervene in the currency markets to achieve a desired exchange rate level

In contrast,

the twelve members of the Single Currency agreed to fully fix their currencies against each other in January 1999

In January 2002,

twelve exchange rates become one when the Euro enters common circulation throughout the Euro Zone

Exchange Rates under Fixed and Floating Regimes With floating exchange rates,

changes in market demand and market supply of a currency cause a change in value

In the diagram below we see the effects of a rise in the demand for sterling

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(perhaps caused by a rise in exports or an increase in the speculative demand for sterling)

This causes an appreciation in the value of the pound

Changes in currency supply also have an effect

In the diagram below there is an increase in currency supply (S1-S2) which puts downward pressure on the market value of the exchange rate

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A currency can operate under one of four main types of exchange rate system:


Value of the currency is determined solely by market demand for and supply of

the currency in the foreign exchange market

Trade flows and capital flows are the main factors affecting the exchange rate In

the long run it is the macro economic performance of the economy (including trends in competitiveness) that drives the value of the currency

No pre-determined official target for the exchange rate is set by the Government

The government and/or monetary authorities can set interest rates for domestic economic purposes rather than to achieve a given exchange rate target

It is rare for pure free floating exchange rates to exist

time or another seek to "manage" the value of their currency through changes in interest rates and other controls

UK sterling has floated on the foreign exchange markets since the UK suspended

membership of the ERM in September 1992


Value of the pound determined by market demand for and supply of the currency

with no pre-determined target for the exchange rate is set by the Government 

Governments normally engage in managed floating if not part of a fixed exchange

Policy pursued from 1973-90 and since the ERM suspension from 1993-1998

MONIRBA Summer Internship 2011


Exchange rate is given a specific target

Currency can move between permitted bands of fluctuation

Exchange rate is dominant target of economic policy-making (interest rates are

Bank of England may have to intervene to maintain the value of the currency

Re-valuations possible but seen as last resort

October 1990


Commitment to a single fixed exchange rate

Achieves exchange rate stability but perhaps at the expense of domestic economic

Bretton-Woods System 1944-1972 where currencies were tied to the US dollar

Gold Standard in the inter-war years

Countries joining EMU in 1999 have fixed their exchange rates until the year

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Present Scenario of Exchange Rate The importance of capital flows in determining exchange rate movements leaves the Domestic foreign exchange markets susceptible to international capital flows

In India,

capital flows have been a dominant source of volatility for not only the exchange rate but also other market segments

When FII investors exit from equity and securities market abruptly in a herd,

stock and bond prices get affected,

and when investors take the redemption proceeds out of the country,

Reserve Bank’s foreign exchange market operations to contain exchange rate volatility,

could tighten domestic liquidity and thereby affect money market

Since capital flows are sensitive to both global developments as well as domestic fundamentals,

at times the domestic financial markets may be solely driven by capital flows

the risk of adverse external shock transmitting through financial markets will have to be recognized and managed timely

During 2009-10,

on the back of short-term capital inflows and positive growth outlook,

rupee generally appreciated against the US dollar,

though marked by intermittent depreciation pressures

An easy supply situation in the market on the back of revival in capital flows also led to moderation in forward premia


even though capital inflows were not excessive in relation to the financing gap in the current account,

the exchange rate appreciated,

reflecting the flexibility of the exchange rate

With the onset of the Greek debt crisis and the associated flight

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the rupee depreciated against the US dollar and the forex market witnessed increased volatility

Despite increasing global market uncertainties emanating from the Euro zone fiscal sustainability concerns,

domestic markets functioned normally in 2010-11 so far,

though with higher volatility in some segments

Domestic equity prices witnessed correction,

albeit with some gains in July 2010

The exchange rate depreciated due to rising pressure on the euro and volatility in FII flows

Domestic money markets faced liquidity pressures,

leading to hardening of short-term money market rates

Responding to these developments,

the Reserve Bank initiated temporary liquidity facilities that helped contain inter-bank call rate around the ceiling of the LAF corridor

Medium to long-term interest rates,

moderated on expectations of lower fiscal deficit of the Government and general safe haven appeal of government bonds

The primary segment of the domestic capital market exhibited larger mobilization of resources in Q1 of 2010-11

Source: RBI Economic review july,

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RISK OF FOREX MARKET This risk usually affects businesses that export and/or import,

but it can also affect investors making international investments

For example,

if money must be converted to another currency to make a certain investment,

then any changes in the currency exchange rate will cause that investment's value to either decrease or increase when the investment is sold and converted back into the original currency

Types of Risk Exchange Rate Risk – refers to the fluctuations in currency prices over a trading period

Prices can fall rapidly resulting in substantial losses unless stop loss orders are used when trading FOREX

Stop loss orders specify that the open position should be closed if currency prices pass a predetermined level

Stop loss orders can be used in conjunction with limit orders to automate FOREX trading – limit orders specify an open position should be closed at a specified profit target

Interest Rate Risk – can result from discrepancies between the interest rates in the two countries represented by the currency pair in a FOREX quote

This discrepancy can result in variations from the expected profit or loss of a particular FOREX transaction

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Credit Risk – is the possibility that one party in a FOREX transaction may not honor their debt when the deal is closed

This may happen when a bank or financial institution declares insolvency

Credit risk is minimized by dealing on regulated exchanges which require members to be monitored for credit worthiness

Country Risk – is associated with governments that may become involved in foreign exchange markets by limiting the flow of currency

There is more country risk associated with 'exotic' currencies than with major currencies that allow the free trading of their currency

Forex Risk Statements The risk of loss in trading the foreign exchange markets can be substantial

You should therefore carefully consider whether such trading is suitable for you in light of your financial condition

In considering whether to trade or authorize someone else to trade for you,

you should be aware of the following: 1

If you purchase or sell a foreign exchange option you may sustain a total loss of the initial margin funds and additional funds that you deposit with your broker to establish or maintain your position

If the market moves against your position,

you could be called upon by your broker to deposit additional margin funds,

in order to maintain your position

If you do not provide the additional required funds within the prescribed time,

your position may be liquidated at a loss,

and you would be liable for any resulting deficit in you account

Under certain market conditions,

you may find it difficult or impossible to liquidate a position

This can occur,

for example when a currency is deregulated or fixed trading bands are widened

Potential currencies include,

but are not limited to the Thai Baht,

South Korean Won,

Malaysian Ringitt,

Brazilian Real,

The placement of contingent orders by you or your trading advisor,

such as a “stop-loss” or “stop-limit” orders,

will not necessarily limit your losses to the intended amounts,

since market conditions may make it impossible to execute such orders

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A “spread” position may not be less risky than a simple “long” or “short” position

The high degree of leverage that is often obtainable in foreign exchange trading can work against you as well as for you

The use of leverage can lead to large losses as well as gains

In some cases,

managed accounts are subject to substantial charges for management and advisory fees

It may be necessary for those accounts that are subject to these charges to make substantial trading profits to avoid depletion or exhaustion of their assets

Currency trading is speculative and volatile Currency prices are highly volatile

Price movements for currencies are influenced by,

among other things: changing supply-demand relationships

exchange control programs and policies of governments

United States and foreign political and economic events and policies

changes in national and international interest rates and inflation

and sentiment of the market place

None of these factors can be controlled by any individual advisor and no assurance can be given that an advisor’s advice will result in profitable trades for a partic0pating customer or that a customer will not incur losses from such events

Currency trading can be highly leveraged The low margin deposits normally required in currency trading (typically between 3%-20% of the value of the contract purchased or sold) permits extremely high degree leverage


a relatively small price movement in a contract may result in immediate and substantial losses to the investor

Like other leveraged investments,

any trade may result in losses in excess of the amount invested

Currency trading presents unique risks The interbank market consists of a direct dealing market,

in which a participant trades directly with a participating bank or dealer,

The brokers’ market differs from the direct dealing market in that the banks or financial institutions serve as intermediaries rather than principals to the transaction

In the brokers’ market,

brokers may add a commission to the prices they communicate to their customers,

or they may incorporate a fee into the quotation of price

Trading in the interbank markets differs from trading in futures or futures options in a number of ways that may create additional risks

For example,

there are no limitations on daily price moves in most currency markets

In addition,

the principals who deal in interbank markets MONIRBA Summer Internship 2011 41

are not required to continue to make markets

There have been periods during which certain participants in interbank markets have refused to quote prices for interbank trades or have quoted prices with unusually wide spreads between the price at which transactions occur

Frequency of trading

degree of leverage used It is impossible to predict the precise frequency with which positions will be entered and liquidated

Foreign exchange trading ,

due to the finite duration of contracts,

the high degree of leverage that is attainable in trading those contracts,

and the volatility of foreign exchange prices and markets,

typically involves a much higher frequency of trading and turnover of positions than may be found in other types of investments

There is nothing in the trading methodology which necessarily precludes a high frequency of trading for accounts managed

Foreign Exchange Exposure Adler and Dumas defines foreign exchange exposure as ‘the sensitivity of changes in the real domestic currency value of assets and liabilities or operating income to unanticipated changes in exchange rate’

In simple terms,

definition means that exposure is the amount of assets

liabilities and operating income that is ay risk from unexpected changes in exchange rates

Types of Foreign Exchange Risks\ Exposure There are two sorts of foreign exchange risks or exposures

The term exposure refers to the degree to which a company is affected by exchange rate changes

 Transaction Exposure  Translation exposure (Accounting exposure)  Economic Exposure  Operating Exposure MONIRBA Summer Internship 2011 42

TRANSACTION EXPOSURE Transaction exposure is the exposure that arises from foreign currency denominated transactions which an entity is committed to complete

It arises from contractual,

For example,

if a firm has entered into a contract to sell computers at a fixed price denominated in a foreign currency,

the firm would be exposed to exchange rate movements till it receives the payment and converts the receipts into domestic currency

The exposure of a company in a particular currency is measured in net terms,

after netting off potential cash inflows with outflows

Suppose that a company is exporting deutsche mark and while costing the transaction had reckoned on getting say Rs 24 per mark

By the time the exchange transaction materializes i

the export is affected and the mark sold for rupees,

the exchange rate moved to say Rs 20 per mark

The profitability of the export transaction can be completely wiped out by the movement in the exchange rate

Such transaction exposures arise whenever a business has foreign currency denominated receipt and payment

The risk is an adverse movement of the exchange rate from the time the transaction is budgeted till the time the exposure is extinguished by sale or purchase of the foreign currency against the domestic currency

TRANSLATION EXPOSURE Translation exposure is the exposure that arises from the need to convert values of assets and liabilities denominated in a foreign currency,

Any exposure arising out of exchange rate movement and resultant change in the domestic-currency value of the deposit would classify as translation exposure

It is potential for change in reported earnings and/or in the book value of the consolidated corporate equity accounts,

as a result of change in the foreign exchange rates

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Translation exposure arises from the need to "translate" foreign currency assets or liabilities into the home currency for the purpose of finalizing the accounts for any given period

A typical example of translation exposure is the treatment of foreign currency borrowings

Consider that a company has borrowed dollars to finance the import of capital goods worth Rs 10000

When the import materialized the exchange rate was say Rs 30 per dollar

The imported fixed asset was therefore capitalized in the books of the company for Rs 300000

In the ordinary course and assuming no change in the exchange rate the company would have provided depreciation on the asset valued at Rs 300000 for finalizing its accounts for the year in which the asset was purchased

If at the time of finalization of the accounts the exchange rate has moved to say Rs 35 per dollar,

the dollar loan has to be translated involving translation loss of Rs50000

The book value of the asset thus becomes 350000 and consequently higher depreciation has to be provided thus reducing the net profit

ECONOMIC EXPOSURE An economic exposure is more a managerial concept than an accounting concept

A company can have an economic exposure to say Yen: Rupee rates even if it does not have any transaction or translation exposure in the Japanese currency

This would be the case for example,

when the company's competitors are using Japanese imports

If the Yen weekends the company loses its competitiveness (vice-versa is also possible)

The company's competitor uses the cheap imports and can have competitive edge over the company in terms of his cost cutting

Therefore the company's exposed to Japanese Yen in an indirect way

OPERATING EXPOSURE Operating exposure is defined by Alan Shapiro as “the extent to which the value of a firm stands exposed to exchange rate movements,

the firm’s value being measured by the present value of its expected cash flows”

Operating exposure is a result of economic consequences

Of exchange MONIRBA Summer Internship 2011 44

rate movements on the value of a firm,

is also known as economic exposure

Transaction and translation exposure cover the risk of the profits of the firm being affected by a movement in exchange rates

On the other hand,

operating exposure describes the risk of future cash flows of a firm changing due to a change in the exchange rate

Operating exposure has an impact on the firm's future operating revenues,

future operating costs and future operating cash flows


operating exposure has a longer-term perspective

Given the fact that the firm is valued as a going concern entity,

its future revenues and costs are likely to be affected by the exchange rate changes

In particular,

it is true for all those business firms that deal in selling goods and services that are subject to foreign competition and/or uses inputs from abroad

Managing Your Foreign Exchange Risk Once you have a clear idea of what your foreign exchange exposure will be and the currencies involved,

you will be in a position to consider how best to manage the risk

The options available to you fall into three categories:




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If you are an international company with exposure to fluctuating foreign exchange rate risk,

you can place a currency hedge (as protection) against potential adverse moves in the forex market that could decrease the value of your holdings

Speculators can hedge existing forex positions against adverse price moves by utilizing combination forex spot and forex options trading strategies

HOW TO HEDGE FOREIGN CURRENCY RISK Before developing and implementing a foreign currency hedging strategy,

we strongly suggest individuals and entities first perform a foreign currency risk management assessment to ensure that placing a foreign currency hedge is,

the appropriate risk management tool that should be utilized for hedging fx risk exposure

Once a foreign currency risk management assessment has been performed and it has been determined that placing a foreign currency hedge is the appropriate action to take,

you can follow the guidelines below to help show you how to hedge forex risk and develop and implement a foreign currency hedging strategy

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Risk Analysis: Once it has been determined that a foreign currency hedge is the proper course of action to hedge foreign currency risk exposure,

one must first identify a few basic elements that are the basis for a foreign currency hedging strategy

Identify Type(s) of Risk Exposure

the types of foreign currency risk exposure will vary from entity to entity

The following items should be taken into consideration and analyzed for the purpose of risk exposure management: (a) both real and projected foreign currency cash flows,

(b) both floating and fixed foreign interest rate receipts and payments,

and (c) both real and projected hedging costs (that may already exist)

The aforementioned items should be analyzed for the purpose of identifying foreign currency risk exposure that may result from one or all of the following: (a) cash inflow and outflow gaps (different amounts of foreign currencies received and/or paid out over a certain period of time),

and (c) foreign currency hedging and interest rate hedging cash flows

Identify Risk Exposure Implications

Once the source(s) of foreign currency risk exposure have been identified,

the next step is to identify and quantify the possible impact that changes in the underlying foreign currency market could have on your balance sheet

In simplest terms,

identify "how much" you may be affected by your projected foreign currency risk exposure

Market Outlook

Now that the source of foreign currency risk exposure and the possible implications have been identified,

the individual or entity must next analyze the foreign currency market and make a determination of the projected price direction over the near and/or long-term future

Technical and/or fundamental analyses of the foreign currency markets are typically utilized to develop a market outlook for the future

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Determine Appropriate Risk Levels: Appropriate risk levels can vary greatly from one investor to another

Some investors are more aggressive than others and some prefer to take a more conservative stance

Risk Tolerance Levels

Foreign currency risk tolerance levels depend on the investor's attitudes toward risk

The foreign currency risk tolerance level is often a combination of both the investor's attitude toward risk (aggressive or conservative) as well as the quantitative level (the actual amount) that is deemed acceptable by the investor

How Much Risk Exposure to Hedge

determining a hedging ratio is often determined by the investor's attitude towards risk

Each investor must decide how much forex risk exposure should be hedged and how much forex risk should be left exposed as an opportunity to profit

Foreign currency hedging is not an exact science and each investor must take all risk considerations of his business or trading activity into account when quantifying how much foreign currency risk exposure to hedge

Determine Hedging Strategy: There are a number of foreign currency hedging vehicles available to investors as explained in items IV

- E above

Keep in mind that the foreign currency hedging strategy should not only be protection against foreign currency risk exposure,

but should also be a cost effective solution help you manage your foreign currency rate risk

Risk Management Group Organization: Foreign currency risk management can be managed by an in-house foreign currency risk management group (if cost-effective),

an in-house foreign currency risk manager or an external foreign currency risk management advisor

The management of foreign currency risk exposure will vary from entity to entity based on the size of an entity's actual foreign currency risk exposure and the amount budgeted for either a risk manager or a risk management group

Risk Management Group Oversight & Reporting

Proper oversight of the foreign currency risk manager or the foreign currency risk management group is essential to succes