Forex Risk Managment.docx

A STUDY ON Foreign Exchange and its Management

Project submitted in partial fulfillment for the award of Degree of

TY B.COM ACCOUNTING AND FINANCE

DECLARATION I hereby declare that this Project Report titled “A STUDY ON FOREIGN EXCHANGE AND ITS RISK MANAGEMENT” submitted by me to the Department “XXXXX” is a bonafide work under taken by me and it is not submitted to any other University or Institution for the award of any degree diploma / certificate or published any time before.

Name and Address of the Student

Signature of the Student

Date

ACKNOWLEDGEMENT

I express my profound gratitude to MR. NILESH KOHLI , Faculty TYBAF for his guidance and support all through the completion of the project.

I also express my hurtful thanks to XXXXX for providing valuable suggestions in completions of the project.

I take this opportunity to acknowledge unreserved support extended to me by the Project and Training team of HCL TECHNOLOGIES.

I am very much indebted to the dedicated and experienced staff of TYBAF.

It is indeed a pleasant task and small effort to thank all the people especially some of my friends who have contributed towards the successful completion of this project work.

Finally, I would like to express my gratitude to my parents for their endearing support and cooperation which has made me complete this project fruitfully

SUMMARY

A Multinational company with high currency risk is likely to face financial difficulties which tend to have a disrupting on the operating side of the business.

A disrupted financial conditions are likely to: 

Result in the problem of adverse incentives.



Weakens the commitment of various stake holders.

Foreign exchange exposure and risk are important concept in the study of international finance. It is the sensitivity of the home currency value of asset, liabilities, or operating incomes to unanticipated changes in the exchange rates. Exposure exists if the home currency values on an average in a particular manner. It also exists where numerous currencies are involved.

Foreign exchange risk is the variance of the home currency value of items arising on account of unanticipated changes in the exchange rates.

The derivative instruments like forwards, futures and options are used to hedge against the foreign exchange risk of the Multinational companies.

The original derivatives contract of International Finance is the ‘Forward exchange contract’. Forward Foreign exchange is a traditional and popular risk management tool to obtain protection against adverse exchange rate movements. The exchange rate is ‘locked in’ for a specific date in future, which enables the person involved in the contract to plan for and budget the business expenses with more certainty. Forward exchange market, has since the 1960s, played the role of linking international interest rates. Today, however, Forward contract have to share other instruments and markets for arbitrage and for hedging. These newer derivative instruments include Futures, Options and Swaps.

CHAPTER NO.1

CHAPTER NO.2

CHAPTER NO.3

INTRODUCTION

RESEARCH AND METHODOLOGY

REVIEW OF LITERATURE

1.1

Introduction of topic

1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9

2.1

Historical background Definition, meaning Characteristics/ objective Features Advantages/ Disadvantages Other related information Different concepts pertaining to problem Profile of the study area Size of population( area ,organization ,etc) Selection Sample size Object of the study area

2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9

Hypothesis Scope of the study Limitation of the study Significance of the study Sample size Data collection Tabulation of data Techniques and tools used

3.1

Introduction Review of literature-different research paper Tabulation view Conclusion

LIST OF TABLES AND GRAPHS Sr.no 1 2 3 4 5 6 7 8 9 10

particulars Table .1 Table.2 Table.3 T able.4 Graph.1 Graph.2 Graph .3 Graph .4 Graph .5

Page no

CHAPTER NO.1 INTRODUCTION

INTRODUCTION TO FOREIGN EXCHNGE Definition of International Trade: International trade refers to trade between the residents of two different countries. Each country functions as a sovereign state with its own set of regulations and currency. The difference in the nationality of the export and the importer presents certain peculiar problem in the conduct of international trade and settlement of the transactions arising there from.

Important among such problems are: a)

Different countries have different monetary units;

b)

Restrictions imposed by counties on import and export of goods:

c)

Restrictions imposed by nations on payments from and into their countries;

d)

Different in legal practices in different countries.

The existing of national monetary units poses a problem in the settlement of international transactions. The exporter would like to get the payment in the currency of own country. For instance, if American exporter of New York export machinery to Indian rupee will not serve their purpose because Indian rupee cannot be used as currency inn rupees. Thus the exporter requires payment in the importer's country. A need, therefore, arises for conversion of the currency of the importer's country into that of the exporters country.

Foreign exchange: Foreign exchange is the mechanism by which the currency of one country gets converted into the currency of another country. The conversion is done by banks who deal in foreign exchange. These banks maintain stocks of foreign currencies in the form of balances with banks abroad. For instance, Indian Bank may maintain an account with Bank of America, new York, in which dollar are held. In the earlier example, if Indian importers pay the equivalent rupee to Indian bank, it would arrange to pay American export at New York in dolor from the dollar balances held by it with Bank of America.

Exchange rate: The rate at which one currency is converted into another currency is the rate of exchange between the currencies concerned. The rate of exchange for a currency is known from the quotation in the foreign exchange market.

In the illustration, if Indian bank exchanged us for Indian rupee at Rs.40 a dollar, the exchange rate between rupee and dollar can be expressed as

USD 1=Rs.40.

The banks operating at a financial center, and dealing in foreign exchange, constitute the foreign exchange market. As in any commodity or market, the rates in the foreign exchange market are determined by the interaction of the forces of demand and supply of the commodity dealt, viz., foreign exchange. Since the demand and supply are affected by a number of factors, both fundamental and transitory, the rates keep on changing frequently, and violently too.

Some of the important factors which affect exchange rates are: 

Balance of payments



Inflation



Interest rates



Money Supply



National Income



Resource Discoveries



Capital Movements



Political Factors



Psychological Factors and Speculation



Technical and Market Factors

Balance of payment:

It represents the demand for and supply of foreign exchange which

ultimately determine the value of the currency. Exporters from the country demand for the currency of the country in the forex market. The exporters would offer to the market the foreign currencies have acquired and demand in exchange the local currency. Conversely, imports into the country will increase the supply of currency of the country in the forex market. When the BOP of a country is continuously at deficit, it implies that demand for the currency of the country is lesser than the supply. Therefore, its value in the market declines. If the BPO is surplus, continuously, it shows the demand for the currency is higher than its supply and therefore the currency gains in value.

Inflation: inflation in the country would increase the domestic prices of the commodities. With increase in prizes exports may dwindle because the price may not be competitive. With the decrease in export the demand for the currency would also decline; this it in turn would result in the decline of external value of the currency. It should be noted that it is the relative rate of inflation in the two counties that cause changes in the exchange rates.

Interest rates:

The interest rate has a great influence on the short-term movement of

capital. When the interest rate at a center rises, it attracts short term funds from other centers. This would increase the demand for the currency at the center and hence its value. Rising of interest rate may be adopted by a country due to money conditions or as a deliberate attempt to attract foreign investment.

Money supply: An increase in money supply in the country will affect the exchange rates through causing inflation in the country. It can also affect the exchange rate directly.

National income:

An increase in national income reflects increase in the income of the

residents of the country. The increase in the income increases the demand for goods in the country. If there is underutilized production capacity in the country, this would lead to increase in production. There is a change for growth in exports too. Where the production does not increase in sympathy with income rises, it leads to increased imports and increased supply of the currency of the country in the foreign exchange market. The result is similar to that of inflation viz., and decline in the value of the currency. Thus an increase in national income will lead to an increase in investment or in the consumption, and accordingly, its effect on the exchange rate will change.

Resource discoveries: When the country is able to discover key resources, its currency gains in value.

Capital Movements:

There are many factors that influence movement of capital from

one country to another. Short term movement of capital may be influenced by the offer of higher interest in a country. If interest rate in a country rises due to increase in bank rate or otherwise, there will be a flow of short-term funds into the country and the exchange rate of the country will rise. Reserves will happen in case of fall in interest rates.

Bright investment climate and political stability may encourage portfolio investment in the country. This leads to higher demand for the currency and upward trend in its rate. Poor economic outlook may mean repatriation of the investments leading to decreased demand and lower exchange value for the currency of the country. Movement of capital is also caused by external borrowings and assistance. Large-scale external borrowings will increase the supply of foreign exchange in the market. This will have a favorable effect on the exchange rate of the currency of the country. When a repatriation of principal and interest starts the rata may be adversely affected.

Other factors include political factors, Psychological factors and Speculation, Technical and Market factors

INTRODUCTION TO THE FOREIGN EXCHANGE RISK MANAGEMENT Risk: Risk is the possibility that the actual result from an action will deviate from the expected levels of result. The greater the magnitude of deviation and greater the probability of its occurrence, the greater is the risk.

A business has to take step to minimize the risk by adopting appropriate technique or policies. Risk management focuses on identifying and implementing these technique or policies, lest the business should be left exposed to uncertain outcomes.

Risk management: Risk management is a process to identify loss exposure faced by an organization and to select the most appropriate technique such exposures.

Risk management tools measure potential loss and potential gain. It enables us to stay with varying degree of certainty and confidence levels, that our potential loss will not exceed a certain amount if we adopt a particular strategy. Risk management enables us to confront uncertainty head on, acknowledge its existence, try to measure its extent and finally control it.

Risk management makes sense for two reasons. One, a business entity generally wishes to reduce risks to acceptable levels. Two, a business entity is generally keen on avoiding particularly kind of risks, for it may be too great for the business to bear. For each situation where one wishes to avoid a risk- a loss by fire, for example- three is, perhaps, a counter party who may be willing such risk. For risk reduction, a business entity can adopt the following methods. Hedging: Hedging is a technique that enables one party to minimize the effect of adverse outcomes, in a given situation. Parties come together to minimize the effect of which risk of one party gets cancelled by the risk of another. IT is not that risk minimization is the only strategy. An entity may even choose to remain exposed, in anticipation of reaping profits from its risk taking positions.

FOREIGN EXCHANGE EXPOSURE Exposure:

Exposure is defined as the possibility of a change in the assets or liabilities or both of a company as a result in the exchange rate. Foreign exchange exposure thus refers to the possibility of loss or gain to a company that arises due to exchange rate fluctuations.

The value of a firm’s assets, liabilities and operating income vary continually in response to changes in a myriad economic and financial variable such as exchange rates, interest rates, inflation rates, relative price and so forth. We can these uncertainties as macroeconomic environment risks. These risks affect all firms in the economy. However, the extent and nature of impact of even macroeconomic risks crucially depend upon the nature of firm’s business. For instance, fluctuations of exchange rate will

affect net importers and exporters quite differently. The impact of interest rate fluctuations will be very different from that on a manufacturing firm. The nature of macroeconomic uncertainty can be illustrated by a number of commonly encountered situations. An appreciation of value of a foreign currency(or equivalently, a depreciation of the domestic currency), increase the domestic currency value of a firm’s assets and liabilities denominated in the foreign currency-foreign currency receivables and payables, banks deposits and loans, etc. It ill also change domestic currency cash flows from exports and imports. An increase in interest rates reduces the market value of a portfolio of fixed-rate in the rate of inflation may increase value of unsold stocks, the revenue from future sales as well as the future costs of production. Thus the firms exposed to uncertain changes in a numbers of variable in its environment. These variables are sometimes called Risk Factors.

The nature of Exposure and Risk Exposure are a measure of the sensitivity of the value of a financial items (assets, liabilities or cash flow) to changes in the relevant risk factor while risk is a measurable of the variability of the item attributable to the risk factor.

Corporate treasurers have become increasingly concerned about exchange rate and interest rate exposure and risk during the last ten to fifteen years or so. In the case of exchange rate risk, The increased awareness is firstly due to tremendous increase in the volume of cross border financial transactions (which create exposure) and secondly due to the significant increase in the degree of volatility in exchange rates(which, given the exposure, creates risk) Classification of foreign exchange exposure and risk Since the advent of floating exchange rates in 1973, firms around the world have become acutely aware of the fact that fluctuations in exchange rates expose their revenues, costs, operating cash flows and thence their market value to substantial fluctuations. Firms which have cross-border transactions-exports and imports of goods and services, foreign borrowings and lending, foreign portfolio and direst investment etc, are directly exposed: but even purely domestic firms which have absolutely no cross border transactions are also exposed because their customers, suppliers and competition are exposed. Considerably effort has since been devoted to identifying and categorizing currency exposure and developing more and more sophisticated methods to quantify it.

Foreign exchange exposure can be classified into three broad categories: 

Transaction exposure



Translation exposure



Operating exposure

Of these, the first and third together are sometimes called “Cash Flow Exposure” while the second is referred to as “Accounting Exposure” or Balance sheet Exposure”.

Transaction exposure When a firm has a payable or receivable denominated in a foreign currency, a change in the exchange rate will alter the amount of local currency receivable or paid. Such a risk or exposure is referred to as transaction exposure.

For example , if an Indian exporter has a receivable of $100,100 due three months hence and if in the meanwhile the dollar depreciates relative to the rupee a cash loss occurs. Conversely, if the dollar appreciates relative to the rupee, a cash gain occurs. In the case of payable, the outcome is of an opposite kind: a depreciation of the dollar relative to the rupee results in a gain, where as an appreciation of the dollar relative to the rupee result in a loss.

Translation exposure Many multinational companies require that their accounts of foreign subsidiaries and branches get consolidated with those of it. For such consolidation, assets and liabilities expressed in foreign currencies have to be translated into domestic currencies at the exchange rate prevailing on the consolidation dates. If the values of foreign currencies change between a two or successive consolidation dates, translation exposure will arise.

Operating exposure Operating exposure, like translation exposure involve an actual or potential gain or loss. While the former is specific to the transaction, the latter relates to entire investment. The essence of this operating exposure is that exchange rate changes significantly and

alter the cost of firm's inputs along with price of it output and thereby influence its competitive position substantially.

Eg: Volkswagen had a highly successful export market for its ‘beetle’ model in the US before 1970. With the breakdown of Britten-woods of fixes exchanged rates, the deutschemark appreciated significantly against the dollar. This created problem for Volkswagen as its expenses were mainly in deutschemark but its revenue in dollars. However, in a highly price-sensitive US market, such an action caused a sharp decreased in sales volume-from 600,000 vehicles in 1968 to 200,000 in 1976.(Incidentally, Volkswagens 1973 losses were the highest, as of that year, suffered by any company anywhere in the world.)

INTRODUCTION TO HCL TECHNOLOGIES

HCL TECHNOLOGIES

Overview HCL Enterprise is a leading Global Technology and IT enterprise that comprises two companies listed in India - HCL Technologies & HCL Info systems. The 3-decade-old enterprise, founded in 1976, is one of India's original IT garage startups. Its range of offerings span Product Engineering, Custom & Package Applications, BPO, IT Infrastructure Services, IT Hardware, Systems Integration, and distribution of ICT products. The HCL team comprises approximately 45,000 professionals of diverse

nationalities, who operate from 17 countries including 360 points of presence in India. HCL has global partnerships with several leading Fortune 1000 firms, including leading IT

and

technolog

firms.

.

HCL Technologies is one of India's leading global IT Services companies, providing software-led IT solutions, remote infrastructure management services and BPO. Having made a foray into the global IT landscape in 1999 after its IPO, HCL Technologies focuses on Transformational Outsourcing, working with clients in areas that impact and re-define the core of their business. The company leverages an extensive global offshore infrastructure and its global network of offices in 18 countries to deliver solutions across select verticals including Financial Services, Retail & Consumer, Life Sciences & Healthcare, Hi-Tech & Manufacturing, Telecom and Media & Entertainment (M&E). For the quarter ended 30th September 2007, HCL Technologies, along with its subsidiaries had last twelve months (LTM) revenue of US $ 1.5 billion (Rs. 6363 corers) and employed 45,622 professionals.

History of company 

While HCL Enterprise has a 30-year history, HCL Technologies is a relatively young company formed, nine years ago, in 1998. During this period, HCL has built unique strengths in IT applications (custom applications for industry solutions and package implementation), IT infrastructure management and business process outsourcing, while maintaining and extending its leadership in product engineering. HCL has also built domain depth through a micro-virtualization strategy in industries such as Financial Services, Hi-tech and Manufacturing, Retail, Media and Entertainment, Life Sciences,

and

Telecom.

HCL has created the ability to distribute value across the customer's IT landscape through its well-distributed services portfolio, significant domain strengths, and locally relevant geographic distribution. HCL has the widest service portfolio among Indian IT service providers, with each of its services having attained critical mass.

Our five mature lines of business are R&D and Engineering, Custom Applications, Enterprise Applications, IT Infrastructure Management, and BPO Services. In addition, HCL has recently launched its Enterprise Transformation Service offerings comprising of Business, Technology, Application and Data Transformation – the four broad needs of any enterprise. Our ability to synergistically integrate these service lines across the entire IT landscape creates new zones for value creation. Additionally, HCL has created unique service leadership in each of these areas through best-of-breed unique propositions. HCL’s leadership in these service areas has been recognized by several leading



independent

analysts.

In 2005, HCL started questioning the linearity of scale-driven business models adopted by service providers (largely in the IT application business). The questioning led us to the belief that the market was rapidly approaching a point of inflection, that is a point where the volume and value proportionality would change, opening up new opportunities for service providers who aspire to focus on value. With this realization, HCL embarked on a transformational journey that focuses on value centricity in customer relationships and on leveraging new market opportunities, while creating a unique employee experience. Hence HCL entered a new phase of evolution – transforming it from a volume-driven service provider to value-centric enterprise that turns technology into competitive advantage for all its customers across the globe. Today HCL’s new way of doing business is being recognized by Harvard, IDC, Fortune, Forbes, Economist, Business Week and the likes.

HISTORICAL BACKGROUND History of Forex: the Gold Standard System The creation of the gold standard monetary system in 1875 is one of the most important events in the history of the forex market. Before the gold standard was created, countries would commonly use gold and silver as method of international payment. The main issue with using gold and silver for payment is that the value of these metals is greatly affected by global supply and demand. For example, the discovery of a new gold mine would drive gold prices down given the sharp increase in gold supply. (For background reading, see The Gold Standard Revisited.) The basic idea behind the gold standard was that governments guaranteed the conversion of currency into a specific amount of gold, and vice versa. In other words, a currency was backed by gold. Obviously, governments needed a fairly substantial gold reserve in order to meet the demand for currency exchanges. During the late nineteenth century, all of the major economic countries had pegged an amount of currency to an ounce of gold. Over time, the difference in price of an ounce of gold between two currencies became the exchange rate for those two currencies. This represented the first official means of currency exchange in history. The gold standard eventually broke down during the beginning of World War I. Due to the political tension with Germany, the major European powers felt a need to complete large military projects, so they began printing more money to help pay for these projects. The financial burden of these projects was so substantial that there was not enough gold at the time to exchange for all the extra currency that the governments were printing. Although the gold standard would make a small comeback during the years between the wars, most countries had dropped it again by the onset of World War II. However, gold never stopped being the ultimate form of monetary value and is generally regarded as a safe haven for those seeking stability. (For more on this, read What Is Wrong With Gold? and Using Technical Analysis In The Gold Markets.)

Bretton Woods System Before the end of World War II, the Allied nations felt the need to set up a monetary system in order to fill the void that was left when the gold standard system was abandoned. In July 1944, more than 700 representatives from the Allies met in Bretton Woods, New Hampshire, to deliberate over what would be called the Bretton Woods system of international monetary management. To simplify, Bretton Woods led to the formation of the following: 

A method of fixed exchange rates;

 

The U.S. dollar replacing the gold standard to become a primary reserve currency; and The creation of three international agencies to oversee economic activity: the International Monetary Fund (IMF), International Bank for Reconstruction and Development, and the General Agreement on Tariffs and Trade (GATT).

The main feature of Bretton Woods was that the U.S. dollar replaced gold as the main standard of convertibility for the world's currencies. Furthermore, the U.S. dollar became the only currency in the world that would be backed by gold. (This turned out to be the primary reason why Bretton Woods eventually failed.) Over the next 25 or so years, the system ran into a number of problems. By the early 1970s, U.S. gold reserves were so low that the U.S. Treasury did not have enough gold to cover all the U.S. dollars that foreign central banks had in reserve. Finally, on August 15, 1971, U.S. President Richard Nixon closed the gold window, essentially refusing to exchange U.S. dollars for gold. This event marked the end of Bretton Woods. Even though Bretton Woods didn't last, it left an important legacy that still has a significant effect today. This legacy exists in the form of the three international agencies created in the 1940s: the International Monetary Fund, the International Bank for Reconstruction and Development (now part of the World Bank) and the General Agreement on Tariffs and Trade (GATT), which led to the World Trade Organization. (To learn more about Bretton Wood, read What Is The International Monetary Fund? and Floating And Fixed Exchange Rates.)

DEFINITION AND MEANING

Foreign Exchange Market Definition: The Foreign Exchange Market is a market where the buyers and sellers are involved in the sale and purchase of foreign currencies. In other words, a market where the currencies of different countries are bought and sold is called a foreign exchange market. The structure of the foreign exchange market constitutes central banks, commercial banks, brokers, exporters and importers, immigrants, investors, tourists. These are the main players of the foreign market, their position and place are shown in the figure below.

At the bottom of a pyramid are the actual buyers and sellers of the foreign currenciesexporters, importers, tourist, investors, and immigrants. They are actual users of the currencies and approach commercial banks to buy it. The commercial banks are the second most important organ of the foreign exchange market. The banks dealing in foreign exchange play a role of “market makers”, in the sense that they quote on a daily basis the foreign exchange rates for buying and selling of the foreign currencies. Also, they function as clearing houses, thereby helping in wiping out the difference between the demand for and the supply of currencies. These banks buy the currencies from the brokers and sell it to the buyers.

The third layer of a pyramid constitutes the foreign exchange brokers. These brokers function as a link between the central bank and the commercial banks and also between the actual buyers and commercial banks. They are the major source of market information. These are the persons who do not themselves buy the foreign currency, but rather strike a deal between the buyer and the seller on a commission basis. The central bank of any country is the apex body in the organization of the exchange market. They work as the lender of the last resort and the custodian of foreign exchange of the country. The central bank has the power to regulate and control the foreign exchange market so as to assure that it works in the orderly fashion. One of the major functions of the central bank is to prevent the aggressive fluctuations in the foreign exchange market, if necessary, by direct intervention. Intervention in the form of selling the currency when it is overvalued and buying it when it tends to be undervalued.

OBJECTIVE The prime motive of corporate forex risk management is the protection of the underlying business from foreign exchange risk. It is that risk to the business which must be managed. Profit can never really be the prime motive for foreign exchange risk management in a corporate. There is really a very thin line dividing the objective of cost reduction or profit motive. The first task in determining the most suitable system for managing foreign exchange exposures is to clarify corporate objectives in this area. The objectives generally outlined below form the base for strategies and technical models. • Maintaining core cover to total exposures ratio, as per forecast of market conditions. • Periodical evaluation of unhedged exposures. • Market intelligence and identification of seasonal factors. • Diversification of currency mix to reduce interest cost on foreign currency borrowings. • Trading on non-dollar exposures to minimize the cross-currency risk and achieve better core rate. • Identifying market opportunities and operate to derive invisible gains/opportunity benefits. • Adopt appropriate hedging strategies to achieve lower interest cost on foreign currency loans.

• Periodical review of interest rate exposures to devise options for reducing the interest cost on foreign currency borrowings.

FEATURES 1. Most Liquid Market in the World: Currency spot trading is the most popular FX instrument around the world, comprising more than 1/3 of the total activity. It is estimated that spot FX trading generates about $1.5 trillion a day in volume, making it the largest most liquid market in the world. Compare that to futures $437.4bn and equities $191bn and you will see that foreign exchange liquidity towers over any other market. Even though there are many currencies all over the world, 80% of all daily transactions involve trading the G-7 currencies i.e. the “majors.” When compared to the futures market, which is fragmented between hundreds of types of commodities, and multiple exchanges and the equities market, with 50,000 listed stocks (the S&P 500 being the majority), it becomes clear that the futures and equities provides only limited liquidity when compared to currencies. Liquidity has its advantages, the primary one being no manipulation of the market. Thin stock and futures markets can easily be pushed up or down by specialists, market makers, commercials, and locals. Spot FX on the other hand takes real buying/selling by banks and institutions to move the market. Any attempted manipulation of the spot FX market usually becomes an exercise in futility. Among the various financial centers around the world, the largest amount of foreign exchange trading takes place in the United Kingdom, even though that nation’s currency—the pound sterling—is less widely traded in the market than several others. The United Kingdom accounts for about 32 percent of the global total; the United

States ranks a distant second with about 18 per cent and Japan is third with 8 percent. Thus, together, the three largest markets—one each in the European, Western Hemisphere, and Asian time zones—account for about 58 percent of global trading. After these three leaders comes Singapore with 7 percent. The large volume of trading activity in the United Kingdom reflects London’s strong position as an international financial center where a large number of financial institutions are located. In the 1998 foreign exchange market turnover survey, 213 foreign exchange dealer institutions in the United Kingdom reported trading activity to the Bank of England, compared with 93 in the United States reporting to the Federal Reserve Bank of New York. In foreign exchange trading, London benefits not only from its proximity to major Eurocurrency credit markets and other financial markets, but also from its geographical location and time zone. In addition to being open when the numerous other financial centers in Europe are open, London’s morning hours overlap with the late hours in a number of Asian and Middle East markets; London’s afternoon sessions correspond to the morning periods in the large North American market. Thus, surveys have indicated that there is more foreign exchange trading in dollars in London than in the United States, and more foreign exchange trading in marks than in Germany. However, the bulk of trading in London, about 85 percent, is accounted for by foreign-owned (non-U.K. owned) institutions, with U.K.-based dealers of North American institutions reporting 49 percent, or three times the share of U.K.-owned institutions there. 2. Most Dynamic Market in the World: Foreign exchange market is the most dynamic market in the world. Regardless of which instrument you are trading – be it stocks, municipal bonds, U.S. treasuries, agricultural futures, foreign exchange, or any of the countless others – the attributes that determine the viability of a market as an investment opportunity remain the same. Namely, good investment markets all possess the following characteristics- liquidity, market transparency, low transaction costs, and fast execution. Based upon these characteristics, the spot FX market is the perfect market to trade. 3. It is a Twenty-Four Hour Market: During the past quarter century, the concept of a twenty-four hour market has become a reality. Somewhere on the planet, financial centers are open for business, and banks

and other institutions are trading the dollar and other currencies, every hour of the day and night, aside from possible minor gaps on weekends. In financial centers around the world, business hours overlap; as some centers close, others open and begin to trade. The foreign exchange market follows the sun around the earth. The International Date Line is located in the western Pacific, and each business day arrives first in the Asia-Pacific financial centers— first Wellington, New Zealand, then Sydney, Australia, followed by Tokyo, Hong Kong, and Singapore. A few hours later, while markets remain active in those Asian centers, trading begins in Bahrain and elsewhere in the Middle East. Later still, when it is late in the business day in Tokyo, markets in Europe open for business. Subsequently, when it is early afternoon in Europe, trading in New York and other U.S. centers start. Finally, completing the circle, when it is mid- or lateafternoon in the United States, the next day has arrived in the Asia-Pacific area, the first markets there have opened, and the process begins again. The twenty-four hour market means that exchange rates and market conditions can change at any time in response to developments that can take place at any time. It also means that traders and other market participants must be alert to the possibility that a sharp move in an exchange rate can occur during an off hour, elsewhere in the world. The large dealing institutions have adapted to these conditions, and have introduced various arrangements for monitoring markets and trading on a twenty- four hour basis. Some keep their New York or other trading desks open twenty-four hours a day, others pass the torch from one office to the next, and still others follow different approaches. However, foreign exchange activity does not flow evenly. Over the course of a day, there is a cycle characterized by periods of very heavy activity and other periods of relatively light activity. Most of the trading takes place when the largest number of potential counterparties is available or accessible on a global basis. Market liquidity is of great importance to participants. Sellers want to sell when they have access to the maximum number of potential buyers/and buyers want to buy when they have access to the maximum number of potential sellers. Business is heavy when both the U.S. markets and the major European markets are open—that is, when it is morning in New York and afternoon in London. In the New York market, nearly two thirds of the day’s activity typically takes place in the

morning hours. Activity normally becomes very slow in New York in the mid- to late afternoon, after European markets have closed and before the Tokyo, Hong Kong, and Singapore markets have- opened. Given this uneven flow of business around the clock, market participants often will respond less aggressively to an exchange rate development that occurs at a relatively inactive time of day, and will wait to see whether the development is confirmed when the major markets open. Some institutions pay little attention to developments in less active markets. Nonetheless, the twenty-four hour market does provide a continuous “real-time” market assessment of the ebb and flow of influences and attitudes with respect to the traded currencies, and an opportunity for a quick judgment of unexpected events. The foreign exchange market provides a kind of never-ending beauty contest or horse race, where market participants can continuously adjust their bets to reflect their changing views. Characteristic # 4. Market Transparency: Price transparency is very high in the FX market and the evolution of online foreign exchange trading continues to improve this, to the benefit of traders. One of the biggest advantages of trading foreign exchange online is the ability to trade directly with the market maker. A reputable forex broker will provide traders with streaming, executable prices. It is important to make a distinction between indicative prices and executable prices. Indicative quotes are those that offer an indication of the prices in the market, and the rate at which they are changing. Executable prices are actual prices where the market maker is willing to buy/sell. Although online trading has reached equities and futures, prices represent the LAST buy/sell and therefore represent indicative prices rather than executable prices. Furthermore, trading online directly with the market maker means traders receive a fair price on all transactions. When trading equities or futures through a broker, traders must request a price before dealing, allowing for brokers to check a trader’s existing position and ‘shade’ the price (in their favor) a few pips depending on the trader’s position. Online trading capabilities in FX also create more efficiency and market transparency by providing real time portfolio and account tracking capability. Traders have access

to real time profit/loss on open positions and can generate reports on demand, which provide detailed information regarding every open position, open order, margin position and generated profit/loss per trade.

Characteristic # 5. International Network of Dealers: The market is made up of an international network of dealers. The market consists of a limited number of major dealer institutions that are particularly active in foreign exchange, trading with customers and (more often) with each other. Most, but not all, are commercial banks and investment banks. These dealer institutions are geographically dispersed, located in numerous financial centers around the world. Wherever located, these institutions are linked to, and in close communication with, each other through telephones, computers, and other electronic means. There are around 2,000 dealer institutions whose foreign exchange activities are covered by the Bank for International Settlements’ central bank survey, and who, essentially, make up the global foreign exchange market. A much smaller sub-set of those institutions accounts for the bulk of trading and market-making activity. It is estimated that there are 100- 200 market-making banks worldwide; major players are fewer than that. At a time when there is much talk about an integrated world economy and “the global village,” the foreign exchange market comes closest to functioning in a truly global fashion, linking the various foreign exchange trading centers from around the world into a single, unified, cohesive, worldwide market. Foreign exchange trading takes place among dealers and other market professionals in a large number of individual financial centers— New York, Chicago, Los Angeles, London, Tokyo, Singapore, Frankfurt, Paris, Zurich, Milan, and many, many others. But no matter in which financial center a trade occurs, the same currencies, or rather, bank deposits denominated in the same currencies, are being bought and sold. A foreign exchange dealer buying dollars in one of those markets actually is buying a dollar-denominated deposit in a bank located in the United States, or a claim of a bank abroad on a dollar deposit in a bank located in the United States. This holds true regardless of the location of the financial center at which the dollar deposit is purchased. Similarly, a dealer buying Deutsche marks, no matter where the purchase is made, actually is buying a mark deposit in a bank in Germany or a claim on a mark deposit in a bank in Germany. And so on for other currencies.

Each nation’s market has its own infrastructure. For foreign exchange market operations as well as for other matters, each country enforces its own laws, banking regulations, accounting rules, and tax code, and, as noted above, it operates its own payment and settlement systems. Thus, even in a global foreign exchange market with currencies traded on essentially the same terms simultaneously in many financial centers, there are different national financial systems and infrastructures through which transactions are executed, and within which currencies are held. With access to all of the foreign exchange markets generally open to participants from all countries, and with vast amounts of market information transmitted simultaneously and almost instantly to dealers throughout the world, there is an enormous amount of cross border foreign exchange trading among dealers as well as between dealers and their customers. At any moment, the exchange rates of major currencies tend to be virtually identical in all of the financial centers where there is active trading. Rarely are there such substantial price differences among major centers as to provide major opportunities for arbitrage. In pricing, the various financial centers that are open for business and active at any one time are effectively integrated into a single market. Accordingly, a bank in the United States is likely to trade foreign exchange at least as frequently with banks in London, Frankfurt, and other open foreign centers as with other banks in the United States. Surveys indicate that when major dealing institutions in the United States trade with other dealers, 58 percent of the transactions are with dealers located outside the United States. Dealer institutions in other major countries also report that more than half of their trades are with dealers that are across borders; dealers also use brokers located both domestically and abroad.

Characteristic # 6. Most Widely Traded Currency is the Dollar:

The dollar is by far the most widely traded currency. According to the 1998 survey, the dollar was one of the two currencies involved in an estimated 87 percent of global foreign exchange transactions, equal to about $1.3 trillion a day. In part, the widespread use of the dollar reflects its substantial international role as – “investment” currency in many capital markets, “reserve” currency held by many central banks, “transaction” currency in many international commodity markets, “invoice” currency in many contracts, and “intervention” currency employed by monetary authorities in market operations to influence their own exchange rates. In addition, the widespread trading of the dollar reflects its use as a “vehicle” currency in foreign exchange transactions, a use that reinforces, and is reinforced by, its international role in trade and finance. For most pairs of currencies, the market practice is to trade each of the two currencies against a common third currency as a vehicle, rather than to trade the two currencies directly against each other. The vehicle currency used most often is the dollar, although by the mid-1990s the Deutsche mark also had become an important vehicle, with its use, especially in Europe, having increased sharply during the 1980s and ’90s. Thus, a trader wanting to shift funds from one currency to another, say, from Swedish krona to Philippine pesos, will probably sell krona for U.S. dollars and then sell the U.S. dollars for pesos. Although this approach results in two transactions rather than one, it may be the preferred way, since the dollar/Swedish krona market, and the dollar/Philippine peso market are much more active and liquid and have much better information than a bilateral market for the two currencies directly against each other. By using the dollar or some other currency as a vehicle, banks and other foreign exchange market participants can limit more of their working balances to the vehicle currency, rather than holding and managing many currencies, and can concentrate their research and information sources on the vehicle. Use of a vehicle currency greatly reduces the number of exchange rates that must be dealt with in a multilateral system. In a system of 10 currencies, if one currency is selected as vehicle currency and used for all transactions, there would be a total of nine currency pairs or exchange rates to be dealt with (i.e., one exchange rate for the vehicle currency against each of the others), whereas if no vehicle currency were used, there would be 45 exchange rates to be dealt with. In a system of 100 currencies with no vehicle currencies, potentially there would be 4,950 currency pairs or exchange rates [the formula is- n(n-1)/2].Thus, using a vehicle

currency can yield the advantages of fewer, larger, and more liquid markets with fewer currency balances, reduced informational needs, and simpler operations. The U.S. dollar took on a major vehicle currency role with the introduction of the Bretton Woods par value system, in which most nations met their IMF exchange obligations by buying and selling U.S. dollar to maintain a par value relationship for their own currency against the U.S. dollar. The dollar was a convenient vehicle, not only because of its widespread use as a reserve currency, but also because of the presence of large and liquid dollar money and other financial markets, and , in time, the Euro-dollar markets where dollars needed for (or resulting from) foreign exchange transactions could conveniently be borrowed (or placed). Changing conditions in the 1980s and 1990s altered this situation. In particular, the Deutsche mark began to play a much more significant role as a vehicle currency and, more importantly, in direct “cross trading.” As the European Community moved toward economic integration and monetary unification, the relationship of the European Monetary System (EMS) currencies to each other became of greater concern than the relationship of their currencies to the dollar. An intra-European currency market developed, centering on the mark and on Germany as the strongest currency and largest economy. Direct intervention in members’ currencies, rather than through the dollar, became widely practiced. Events such as the EMS currency crisis of September 1992, when a number of European currencies came under severe market pressure against the mark, confirmed the extent to which direct use of the DEM for intervening in the exchange market could be more effective than going through the dollar. Against this background, there was very rapid growth in direct cross rate trading involving the Deutsche mark, much of it against European currencies, during the 1980s and ’90s. (A “cross rate” is an exchange rate between two non-dollar currencies —e.g., DEM/ Swiss franc, DEM/pound, and DEM/yen). There are derived cross rates calculated from the dollar rates of each of the two currencies,- and there are direct cross rates that come from direct trading between the two currencies—which can result in narrower spreads where there is a viable market. In a number of European countries, the volume of trading of the local currency against the Deutsche mark grew to exceed local currency trading against the dollar,

and the practice developed of using cross rates between the DEM and other European currencies to determine the dollar rates for those currencies. With its increased use as a vehicle currency and its role in cross trading, the Deutsche mark was involved in 30 percent of global currency turnover in the 1998 survey. That was still far below the dollar (which was involved in 87 percent of global turnover), but well above the Japanese yen (ranked third, at 21 percent), and the pound sterling (ranked fourth, at 11 percent). 7. “Over-The-Counter” Market with an “Exchange-Traded” Segment: Until the 1970s, all foreign exchange trading in the United States (and elsewhere) was handled “over-the-counter,” (OTC) by banks in different locations making deals via telephone and telex. In the United States, the OTC market was then, and is now, largely unregulated as a market. Buying and selling foreign currencies is considered the exercise of an express banking power. Thus, a commercial bank or Securities & brokerage firms in the United States do not need any special authorization to trade or deal in foreign exchange. There are no official rules or restrictions in the United States governing the hours or conditions of trading. The trading conventions have been developed mostly by market participants. There is no official code prescribing what constitutes good market practice. However, the Foreign Exchange Committee, an independent body sponsored by the Federal Reserve Bank of New York and composed of representatives from institutions participating in the market, produces and regularly updates its report on Guidelines for Foreign Exchange Trading. These Guidelines seek to clarify common market practices and offer “best practice recommendations” with respect to trading activities, relationships, and other matters. Although the OTC market is not regulated as a market in the way that the organized exchanges are regulated, regulatory authorities examine the foreign exchange market activities of banks and certain other institutions participating in the OTC market. As with other business activities in which these institutions are engaged, examiners look at trading systems, activities, and exposure, focusing on the safety and soundness of the institution and its activities. Examinations deal with such matters as capital adequacy, control systems, disclosure, sound banking practice, legal compliance, and other factors relating to the safety and soundness of the institution.

The OTC market accounts for well over 90 percent of total U.S. foreign exchange market activity, covering both the traditional (pre-1970) products (spot, outright forwards, and FX swaps) as well as the more recently introduced (post-1970) OTC products (currency options and currency swaps). On the “organized exchanges,” foreign exchange products traded are currency futures and certain currency options. Steps are being taken internationally to help improve the risk management practices of dealers in the foreign exchange market, and to encourage greater transparency and disclosure.

ADVANTAGES /DISADVANTAGES ADVANTAGES OF FOREX MARKET

The biggest financial market in the world is the biggest market because it provides some advantages to its participants. Some of the major advantages offered are as follows: 1. Flexibility Forex exchange markets provide traders with a lot of flexibility. This is because there is no restriction on the amount of money that can be used for trading. Also, there is almost no regulation of the markets. This combined with the fact that the market operates on a 24 by 7 basis creates a very flexible scenario for traders. People with regular jobs can also indulge in Forex trading on the weekends or in the nights. However, they cannot do the same if they are trading in the stock or bond markets or their own countries! It is for this reason

that Forex trading is the trading of choice for part time traders since it provides a flexible schedule with least interference in their full time jobs. Transparency: The Forex market is huge in size and operates across several time zones! Despite this, information regarding Forex markets is easily available. Also, no country or Central Bank has the ability to single handedly corner the market or rig prices for an extended period of time. Short term advantages may occur to some entities because of the time lag in passing information. However, this advantage cannot be sustained over time. The size of the Forex market also makes it fair and efficient! 2. Trading Options Forex markets provide traders with a wide variety of trading options. Traders can trade in hundreds of currency pairs. They also have the choice of entering into spot trade or they could enter into a future agreement. Futures agreements are also available in different sizes and with different maturities to meet the needs of the Forex traders. Therefore, Forex market provides an option for every budget and every investor with a different appetite for risk taking. Also, one needs to take into account the fact that Forex markets have a massive trading volume. More trading occurs in the Forex market than anywhere else in the world. It is for this reason that Forex provides unmatched liquidity to its traders who can enter and exit the market in a matter of seconds any time they feel like! 3. Transaction Costs Forex market provides an environment with low transaction costs as compared to other markets. When compared on a percentage point basis, the transaction costs of trading in Forex are extremely low as compared to trading in other markets. This is primarily because Forex market is largely operated by dealers who provide a two way quote after reserving a spread for themselves to cover the risks. Pure play brokerage is very low in Forex markets. 4. Leverage Forex markets provide the most leverage amongst all financial asset markets. The arrangements in the Forex markets provide investors to lever their original investment by as many as 20 to 30 times and trade in the market! This magnifies both profits and gains. Therefore, even though the movements in the Forex market are usually small, traders end up gaining or losing a significant amount of money thanks to leverage!

DISADVANTAGES OF FOREX MARKET

It would be a biased evaluation of the Forex markets if attention was paid only to the advantages while ignoring the disadvantages. Therefore, in the interest of full disclosure, some of the disadvantages have been listed below: 1. Counterparty Risks Forex market is an international market. Therefore, regulation of the Forex market is a difficult issue because it pertains to the sovereignty of the currencies of many countries. This creates a scenario wherein the Forex market is largely unregulated. Therefore, there is no centralized exchange which guarantees the risk free execution of trades. Therefore, when investors or traders enter into trades, they also have to be cognizant of the default risk that they are facing i.e. the risk that the counterparty may not have the intention or the ability to honor the contracts. Forex trading therefore involves careful assessment of counterparty risks as well as creation of plans to mitigate them. 2. Leverage Risks Forex markets provide the maximum leverage. The word leverage automatically implies risk and a gearing ratio of 20 to 30 times implies a lot of

risk! Given the fact that there are no limits to the amount of movement that could happen in the Forex market in a given day, it is possible that a person may lose all of their investment in a matter of minutes if they placed highly leveraged bets. Novice investors are more prone to making such mistakes because they do not understand the amount of risk that leverage brings along! 3. Operational Risks Forex trading operations are difficult to manage operationally. This is because the Forex market works all the time whereas humans do not! Therefore, traders have to resort to algorithms to protect the value of their investments when they are away. Alternatively, multinational firms have trading desks spread all across the world. However, that can only be done if trading is conducted on a very large scale. Therefore, if a person does not have the capital or the know how to manage their positions when they are away, Forex markets could cause a significant loss of value in the nights or on weekends. The Forex market caters to different types of investors with different risk appetites.

OTHER RELATED INFORMATION ADMINISTRATION FRAME WORK FOR FOREIGN EXCHANGE IN INDIA

The Central Government has been empowered under Section 46 of the Foreign Exchange Management Act to make rules to carry out the provisions of the Act. Similarly, Section 47 empowers the Reserve Bank to make regulations to carry out the provisions of the Act and the rules made there under.

The Foreign Contribution (Regulation) Act, 1976 is to regulate the acceptance and utilization of foreign contribution/ donation or foreign hospitality by certain persons or associations , with a view to ensuring that Parliamentary institutions, political associations and academic and other voluntary organizations as well as individuals working in the important areas of national life may function in a manner consistent with the values of a sovereign democratic republic.

It is basically an act to ensure that the integrity of Indian institutions and persons is maintained and that they are not unduly influenced by foreign donations to the prejudice of India’s interests. The Foreign Exchange Management Act (FEMA) is a law to replace the draconian Foreign Exchange Regulation Act, 1973. Any offense under FERA was a criminal offense liable to imprisonment, Whereas FEMA seeks to make offenses relating to foreign exchange civil offenses. Unlike other laws where everything is permitted unless specifically prohibited, under FERA nothing was permitted unless specifically permitted. Hence the tenor and tone of the Act was very drastic. It provided for imprisonment of even a very minor offense. Under FERA, a person is presumed innocent unless he is proven guilty. With liberalization, a need was felt to remove the drastic measure of FERA and replace them by a set of liberal foreign exchange management regulations. Therefore FEMA was enacted to replace FERA. FEMA extends to the whole of India. It applies to all Branches, offences and agencies outside India owned or controlled by a person resident in India and also to any contravention there under committed outside India by any person to whom this Act applies.

FEMA contains definitions of certain terms which have been used throughout the Act. The meaning of these terms may differ under other laws or common language. But for the purpose of FEMA, the terms will signify the meaning as defined there under.

Authorized persons: With the Reserve Bank has the authority to administer foreign exchange in India, it is recognized that it cannot do so by itself. Foreign exchange is received or required by a large number of exports and imports in the country spread over a vast geographical area. It would be impossible for the reserve Bank to deal with them individually. Therefore, provisions has been made in the Act, enabling the Reserve Bank to authority any person to be known as authority person to deal in the foreign exchange or foreign securities, as an authorized dealer, money changer or off- shore banking unit or any other manner as it deems fit.

Authorized dealers: A major portion of actual dealing in foreign exchange from the customers (importers, exporters and others receiving or making personal remittance) is dealt with by such of the banks in India which have been authorized by Reserve Bank to deal in foreign exchange. Such of the banks and selected financial institutions who have been authorized Dealer.

Fig: ADMINISTRATION OF FOREIGN EXCHANGE IN INDIA

FOREIGN EXCHANGE MANAGEMENT ACT

CENTRAL GOVERNMENT

RESERVE BANK OF INDIA

AUTHORISED PERSONS

FOREIGN EXCHANGE DEALER ASSOCIATION OF INDIA

AUTHORISED MONEY CHANGERS

ATHORISED DEALERS

FULL FLEDGE

RESTRICTED

FOREIGN EXCHANGE DEALER’S ASSOCIATION OF INDIA (FEDAI)

FEDAI was establishing in 1958 as an association of all authorized dealers in India. The principal functions of FEDAI are:

To frame rules for the conduct of foreign exchange business in India. These rules cover various aspects like hours of business, charges for foreign exchange transactions, quotation of rates to customer, interbank dealings, etc. All authorized dealers have given undertaking to the Reserve Bank to abide these rules.

To coordinate with Reserve Bank of India in Proper administration of exchange control.

To control information likely to be of interest to its members.

Thus, FEDAI provides a vital link in the administrative set-up of foreign exchange in India.

AUTHORIZED MONEY CHANGERS To provide facilities for encashment of foreign currency for tourists, etc., Reserve Bank has granted limited licenses to certain established firms, hotels and other organizations permitting them to deal in foreign currency notes, coins and travelers’ cheques subject to directions issued

to them from time to time. These firms and organizations are called ‘Authorized Money Changers’. An authorized money changer may be a full fledged money changer or a restricted money changer. A full fledged money changer is authorized to undertake both purchase and sale transactions with the public. A restricted money changer is authorized only to purchase foreign currency notes, coins and travelers’ cheques subject to the condition that all such collections are surrendered by him in turn to authorized dealer in foreign exchange. The current thinking of the Reserve Bank is to authorize more establishments as authorized money changers in order to facilitate easy conversion facilities.

THE FOREIGN EXCHANGE MARKET The Foreign exchange market is the market where in which currencies are bought and sold against each other. It is the largest market in the world. It is to be distinguished from a financial market where currencies are borrowed and lent.

Foreign exchange market facilitate the conversion of one currency to another for various purposes like trade, payment for services, development projects, speculation etc. Since the number of participants in the market s has increased over the years have become highly competitive and efficient.

With improvement in trade between countries, there was a pressing need to have some mechanism to facilitate easy conversion of currencies. This has been made possible by the foreign exchange markets.

Considering international trade, a country would prefer to import goods for which it does not have a competitive advantage, while exporting goods for which it has a competitive advantage over others. Thus trade between countries is important for common good but nations are separated by distance, which that there is a lot of time between placing an order and its actual delivery. No supplier would be willing to wait until actual delivery for receiving payments. Hence, credit is very important at every stage of the transaction. The much needed credit servicing and conversion of the currency is facilitated by the foreign exchange market.

Also the exchange rates are subject to wide fluctuations. There is therefore, a constant risk associated exchange markets cover the arising out of the fluctuations in exchange rates through “hedging”. Forex market is not exactly a place and that there is no physical meeting but meeting is affected by mail or over phone.

FOREIGN EXHANGE TRANSACTIONS

Foreign exchange transactions taking place in foreign exchange markets can be broadly classified into Interbank transactions and Merchant transactions. The foreign exchange transactions taking place among banks are known as interbank transactions and the rates quoted are known as interbank rates. The foreign exchange transactions that take place between a bank and its customer known as’ Merchant transactions’ and the rates quoted are known as merchant rates.

Merchant transactions take place when as exporter approaches his bank to convert his sale proceeds to home currency or when an importer approaches his banker to convert domestic currency into foreign currency to pay his dues on import or when a resident approaches his bank to convert foreign currency received by him into home currency or vice versa. When a bank buys foreign exchange from a customer it sells the same in the interbank market at a higher rate and books profit. Similarly, when a bank sells foreign exchange to a customer, it buys from the interbank market, loads its margin and thus makes a profit in the deal.

The modes of foreign exchange remittances Foreign exchange transactions involve flow of foreign exchange into the country or out of the country depending upon the nature of transactions. A purchase transaction results in inflow of foreign exchange while a sale transaction result in inflow of foreign exchange. The former is known as inward remittance and the latter is known as outward remittance.

Remittance could take place through various modes. Some of them are:



Demand draft



Mail transfer



Telegraphic transfer



Personal cheques

Types of buying rates:



TT buying rate and



Bill buying rate

TT buying rate is the rate applied when the transaction does not involve any delay in the realization of the foreign exchange by the bank. In other words, the Nastro account of the bank would already have been credited. This rate is calculated by deducting from the interbank buying rate the exchange margin as determined by the bank.

Bill buying rate: This is the rate to be applied when foreign bill is purchased. When a bill is purchased, the rupee equivalent of the bill values is paid to the exporter immediately. However, the proceeds will be realized by the bank after the bill is presented at the overseas centre.

Types of selling rates: 

TT selling rates



Bill selling rates

TT Selling rate: All sale transactions which do not handling documents are put through at TT selling rates.

Bill Selling rates: This is the rate applied for all sale transactions with public which involve handling of documents by the bank.

Inter Bank transactions: The exchange rates quoted by banks to their customer are based on the rates prevalent in the Inter Bank market. The big banks in the market are known as market makers, as they are willing to pay or sell foreign currencies at the rates quoted by them up to any extent. Depending upon its resources, a bank may be a market in one or few major currencies. When a banker approaches the market maker, it would not reveal its intention to buy or sell the currency. This is done in order to get a fair price from the market maker.

Two way quotations Typically, then quotation in the Inter Bank market is a two- way quotation. It means, the rate quoted by the market maker will indicate two prices, one which it is willing to buy the foreign currency and the other at which it is willing to sell the foreign currency. For example, a Mumbai bank may quote its rate for US dollars as under.

USD 1= Rs.41.15255/1650

More often, the rate would be quoted as 1525/1650 since the players in the market are expected to know the ‘big number’ i.e., Rs.41. in the above quotation, once rate us Rs.41.1525 per dollar and the other rate is Rs.41.1650 per dollar.

Direct quotation It will be obvious that the quotation bank will be to buy dollars at 41.1525 and sell dollars at Rs41.1650. if once dollar bought and sold, the bank makes a profit of 0.0125. In a foreign exchange quotation, the foreign currency is the commodity that is being bought and sold. The exchange quotation which gives the price for the foreign v\currency in term of the domestic currency is known as direct quotation. In a direct quotation, the quoting bank will apply the rule: “buy low’ sell high”.

Indirect quotation There is another way of quoting in the foreign exchange market. The Mumbai bank quote the rate for dollar as:

Rs.100=USD 2.4762/4767

This type of quotation which gives the quality of foreign currency per unit of domestic currency is known as indirect quotation. In this case, the quoting bank will receive USD 2.4767 per Rs.100 while buying dollars and give away USD 2.4762 per Rs.100 while selling dollars In other words, “Buy high, sell low” is applied.

This buying rate is also known as the ‘bid’ rate and the selling rate as the ‘offer’ rate. The difference between these rates is the gross profit for the bank and known as the ‘Spread’.

Spot and forward transactions

The transactions in the Inter Bank market May place for settlement

On the same day; or



Two days later;



Some day late; say after a month

Where the agreement to buy and sell is agreed upon and executed on the same date, the transaction is known as cash or ready transaction. It is also known as value today.

The transaction where the exchange of currencies takes place after the date of contract is known as the Spot Transaction. For instance if the contract is made on Monday, the delivery should take place on Wednesday. If Wednesday is a holiday, the delivery will take place on the next day, i.e., Thursday. Rupee payment is also made on the same day the foreign exchange is received.

The transaction in which the exchange of currencies takes place at a specified future date, subsequent to the spot rate, is known as a forward transaction . The forwards transaction can be for delivery one month or two months or three months, etc. A forward contract for delivery one month means the exchange of currencies will take place after one month from the date of contract. A forwards contract for delivery two months means the exchange of currencies will take place after two months and so on.

Spot and Forwards rates Spot rate of exchange is the rate for immediate delivery of foreign exchange. It is prevailing at a particular point of time. In a forward rate, the quoted is for delivery at a future date, which is usually 30, 60, 90 or 180 days later. The forward rate may be at premium or discount to the spot rate, Premium rate, i.e., forward rate is higher than the spot rate, implies that the foreign currency is to appreciate its value in tae future. May be due to larger demand for goods and services of the country of that currency. The percentage of annualized discount or premium in a forward quote, in relation to the spot rate, is computed by the following.

Forward Premium = (discount )

Forward rate-spot rate * Spot rate

12

No. of months forward

If the spot rate is higher than the forward rate, there is forward discount and if the forward rate higher than the spot rate there is forward premium rate.

Forward margin/Swap points Forward rate may be the same as the spot rate for the currency. Then it is said to be ‘at par’ with the spot rate. But this rarely happens. More often the forward rate for a currency may be costlier or cheaper than its spot rate. The difference between the forward rate and the spot rate is known as the ‘Forward margin’ or ‘Swap Points’. The forward margin may be at a premium or at discount. If the forward margin is at premium, the foreign currency will be costlier under forward rate than under the spot rate. If the forward margin is at discount, the foreign currency will be cheaper for forward delivery than for spot delivery.

Under direct quotation, premium is added to the spot rate to arrive at the forward rate. This is done for both purchase and sale transactions. Discount is deducted from spot rate to arrive at the forward rates.

Other rates Buying rate and selling refers to the rate at which a dealer in forex is willing to buy the forex and sell the forex. In theory, there should not be difference in these rates. But in practices, the selling rate is higher than the buying rate. The forex dealer, while buying the forex pay less rupees, but gets more when he sells the forex. After adjusting for operating expenses, the dealer books a profit through the ‘buy and sell’ rates differences.

Transactions in exchange market consist of purchases and sales of currencies between dealers and customers and between dealers and dealers. The dealers buy forex in the form of bills, drafts and with foreign banks, from customer to enable them to receive payments from abroad. The resulting accumulated currency balances with dealers are disposed of by

selling

instruments to customers who need forex to make payment to foreigners. The selling price for a currency quoted by the dealer (a bank) is slightly higher than the purchase price to give the bank small profit in the business. Each dealer gives a two-way quote in forex.

Single Rate refers to the practices of adopting just rate between the two currencies. A rate for exports, other for imports, other for transaction with preferred area, etc, if adopted by a country, that situation is known as multiple rates.

Fixed rate refers to that rate which is fixed in terms of gold or is pegged to another currency which has a fixed value in terms of gold. Flexible rate keeps the exchange rate fixed over a short period, but allows the same to vary in the long term in view of the changes and shifts in another as conditioned by the free of market forces. The rate is allowed to freely float at all times.

Current rate: Current rate of exchange between two currencies fluctuate from day to day or even minute to minute, due to changes in demand and supply. But these movements take place around a rate which may be called the ‘normal rate’ or the par of exchange or the true rate. International payments are made by different instruments, which differ in their time to maturity. A Telegraphic Transfer (TT) is the quickest means of effecting payments. A T.T rate is therefore, higher than that of any other kind of bill. A sum can be transferred from a bank in one country to a bank in another part of the world by cable or telex. It is thus, the quickest method of transmitting funds from one center to another.

Slight rates applicable in the case of bill instrument with attending delay in maturity and possible loss of instrument in transit, are lower than most other rates.

Similarly, there are other clusters of rates, such as, one month’s rate, 3month’s rate. Longer the duration, lower the price (of the foreign currency in terms of domestic).

The exchange rate between two given currencies may be obtained from the rates of these two currencies in terms of a third currency. The resulting rate is called the Cross rate.

Arbitrage in the foreign exchange market refers to buying a foreign currency in a market where it is selling lower and selling the same in a market where it is bought higher. Arbitrage involves no risk as rates are known in advance. Further, there is no investment required, as the purchase of one currency is financed by the sale of other currency. Arbitrageurs gain in the process of arbitraging.

DIFFERENT CONCEPT PERTAINING TO PROBLEM Forex risk management is one of the most debated topics in trading. On one hand, traders want to reduce the size of a potential loss, but on the other hand, such traders also want to benefit by getting the most out of a single trade. It's no secret that in order to gain the highest returns, you need to take greater risks. This is where the question of proper risk management arises. In this article, we will discuss Forex trading risk management and how to manage Forex risk when trading. This can help you to avoid loss, and completely engage in your trading activities without worry.

What is Forex Risk? The Forex market is one of the biggest financial markets on the planet, with everyday transactions totalling more than 1.4 trillion US dollars. Banks, financial establishments, and individual investors therefore have the potential to make huge profits and losses. Forex trade risk is simply the potential loss or profit which occurs as a result of a change in exchange rates. To minimise the likelihood of financial loss, each investor needs to have in place some Forex risk management actions, strategies, and precautions. A lot of people today are engaged with trading activities within the foreign exchange market. However, most of them are not in a position to achieve the profits that they expect. Some traders will lose all of their money, while some fail to get the results they expected. In fact, only a small share of traders are ever able to meet or even

surpass their expectations. The Forex market is constantly changing, and this brings great risks that all traders have to work with. Therefore, the topic of Forex trading risk control is an increasingly popular subject amongst Forex traders.

Common Mistakes in Managing Risk in Forex Trading One of the fundamental ground rules of risk management in the Forex market is that you should never risk more than you can afford to lose. That being said, this mistake is extremely common, especially amongst Forex traders just starting out. The Forex market is highly unpredictable, so traders who are willing to put in more than they can actually afford make themselves very vulnerable to Forex risks. Anything can affect the Forex market - the smallest piece of news can affect the price of a particular currency in a negative or a positive way. Instead of 'going all in', it is better to follow a more moderate path, and trade conservative amounts of capital.

Emotional management strategies and risk Forex traders need to have the ability to control their emotions. If you cannot control your emotions, you won't be able to reach a position where you can achieve the profits you want from trading. Market sentiment can often trap traders in volatile market positions. This is one of the most common Forex trading risks. Those who have a stubborn nature don't tend to perform well in the Forex market. These types of traders tend to have a tendency to wait too long to exit a position. When a trader realizes their mistake, they need to leave the market, taking the smallest loss possible. Waiting too long may cause the trader to end up losing substantial capital. Once out, traders need to be patient and re-enter the market when a genuine opportunity presents itself.

How to get better at forex risk management Fortunately, several methods are available to help Forex traders avoid these mistakes and to avoid loss. You should have a well-tested trading plan which includes all the details concerning risk management in Forex. The trading plan should be practical and you should be able to follow its steps easily. Experts recommend that it is better to focus on higher probability trades.

The Forex trading industry contains a high level of risk, so it isn't necessarily the best discipline for all investors. You also need to be able to pay extra attention to mistakes, and engage in your trading activities on the foreign exchange market. The time and effort that you spend creating a trading plan is often considered as a great investment that will help towards a profitable future.

PROFILE OF THE STUDY AREA INDUSTRY PROFILE The vision of information Technology (IT) policy is to use It as a tool for raising the living standards of the common man and enriching their lives. Though, urban India has a high internet density, the government also wants PC and Internet penetration in the rural India.

In Information technology (IT), India has built up valuable brand equity in the global markets. In IT-enables services (ITES), India has emerged asa the most preferred destination for business process outsourcing (BPO),a key driver of growth for the software industry and the services sector.

India's most prized resource in today's knowledge economy is its readily available technical work force. India has the second largest English speaking scientific professionals in the world, second only to the U.S.

According the data from ministry of communication and information technology, the ITES-BPO industry has grown by 54 per cent with export earnings of US$ 3.6 billion during 2003-2004. Output of the Indian electronic and IT industry is estimated to have grown by 18.2 percent to Rs.1,14,650 corers in 2003-2004.

The share of hardware and non-software services in the IT sector has declined consistently every year in the recent past. The share of software services in electronic and IT sector has gone up from 38.7 per cent in 1998-99 to 61.8 percent in 2003-04.

However, there has been some welcome acceleration in the hardware sector with a sharp deceleration in the rate of decline of hardware's share in electronic and IT industry. Output of computers in value terms, for example, increased by 36.0, 19.7 and57.6 percent in 2000-01, 2002-03, and 2003-04, respectively.

All the sub-sectors of the non- software components of electronic and It industry grew at over 8 percent in 2003-04, but this was far below the rate of growth of software services. Overall, after declining precipitously from 61.4 percent in 1998-99 to 40.9 percent in 2001-02, the share of hardware in this important industry declined only marginally to 38.2 percent in the two subsequent years.

Exports markets continue to dominant the domestic segment. The size of the domestic market in software relative to the export market for Indian software, which was 45.2 percent in 1998-99, after declining rapidly to 29.8 percent in 001-02, fell only to 29.1 percent and 27.7 percent in the two subsequent years.

Value of software and services export is estimated to have increased by 30 percent to US$12.5 billion in 2003-04. The software technology parks of India have reported software exports of RS.31,578 corers ( US$6,947 million) during April-December 2004-2005 as against Rs.22,678 corers (US$4,913) during the corresponding period last year.

The annual growth rate of India's software exports has been consistently over 50 percent since 1991. No other Indian industry has performed so well against the global competition.

According to a NASCOM-McKinsey report, annual revenue projections for India's It industry in 2008 area US$ 87 billion and market openings are emerging across four

broad sectors, IT services, software products, IT enabled services, IN addition to the export market, all of these segments have a domestic market competition as well.

The IT- enabled services industry in India began to evolve in the early nineties when companies such as America Express, British Airways, GE and Swissair set up their offshore operations in India.

Today a large number of foreign affiliates operate IT- enabled services in India. The different services lines of IT enabled services offshore to India include customer care, finance, human resources, billing and payment services, administration and content development. MAJOR STEPS TAKEN FOR PROMOTION OF IT INDUSTRY With the formation of a ministry for IT, Government of India has taken a major step towards promoting the domestic industry and achieving the full potential of he Indian IT entrepreneurs. Constraints have been comprehensively identified and steps taken to overcome them and also to provide incentives. In order to broaden the internet base, the Department of Information technology has also announced a programme to establish State Wide Area Net work (SWAN) up to the block level to provide connectivity for e-governance. The Department also set up community Information centers (CICs) in hilly, far-flung areas of the North-East and Jammu and Kashmir to facilitate the spread of benefit of information and communication technology. It is also proposed to set up CICs in other hilly, far-flange areas of the country like Uttaranchal, Andaman & Nicobar and Lakshadweep.

A number of steps have taken to meet the challenge of zero duty regime in 2005 under the Information Technology Agreement (ITA-1) Tariffs on raw materials, parts, other inputs and capital goods have been rationalized to make domestic manufacturing viable and competitive.

CHAPTER NO.2 RESEARCH AND METHODOLOGY

OBJECT OF THE STUDY AREA OBJECTIVES OF THE STUDY



To study and understand the foreign exchange.



To study and analyze the revenues of the company when the exchange rates fluctuate.



To analyze income statement and find out the revenues when the dollars are converted into Indian rupees.



To study the different types of foreign exchange exposure including risk and risk management techniques which the company is used to minimize the risk.



To present the findings and conclusions of the company in respect of foreign exchange risk management

HYPOTHESIS H0- By investing in foreign exchange market company can safe their investment and get something in return. and hedging the risk of loss is possible.

H1-by investing in foreign exchange market company cannot safe their investment and can't get something in return .and hedging the risk of loss is no possible.

SCOPE OF THE STUDY

1.foreign exchange market is safer than stock market. 2.forex market or mutual fund. 3.participants of forex market.

LIMITATION OF STUDY LIMITATIONS 

The study is confined just to the foreign exchange risk but not the total risk.



The analysis of this study is mainly done on the income statements.



This study is limited for the year 2006-2007.



It does not take into consideration all Indian companies foreign exchange risk.



The hedging techniques are studied only which the company adopted to minimize foreign exchange risk.

ASSUMPTIONS 

The total revenues are assumed 40% as domestic & 60% as foreign revenues.



The exchange rates are taken averagely.



The information collected from various websites are assumed to be accurate and true.



Risk management is an integral part of an organization policy and is inevitable.

SIGNIFICANCE OF STUDY

NEED AND IMPORTANCE OF THE STUDY The world nations are increasingly becoming more interrelated global trade, and global investment. These international result in cross country flow of world nations. Countries hold currencies of other countries and that a market, dealing of foreign exchange results.

Foreign exchange means reserves of foreign currencies. More aptly, foreign exchange refers to claim to foreign money balances. Foreign exchange gives resident of one country a financial claim on other country or countries. All deposits, credits and balances payable in foreign currency and any drafts, travelers cheques, letters of credit and bills of exchange payable in foreign currency constitute foreign exchange. Foreign exchange market is the market where money denominated in one currency is bought and sold with money denominated in another currency. Transactions in currencies of countries, parties to these transactions, rates at which one currency is exchanged for other or others, ramification in these rates, derivatives to the currencies and dealing in them and related aspects constitute the foreign exchange (in short, forex) market.

Foreign exchange transactions take place whenever a country imports goods and services, people of a country undertake visits to other counties, citizens of a country remit money abroad for whatever purpose, business units set up foreign subsidiaries and so on. In all these cases the nation concerned buys relevant and required foreign exchange, in exchange of its currency, or draws from foreign exchange reserves built. On the other hand, when a country exports goods and services to another country, when people of other countries visit the country, when citizens of the country settled abroad remit money homewards, when foreign citizens, firms and institutions invest in the country and when the country or its business community raises funds from abroad, the country's currency is bought by others, giving foreign exchange, in exchange.

Multinational firms operate in more than one country and their operations involve multiple foreign currencies. Their operations are influenced by politics and the laws of the counties where they operate. Thus, they face higher degree of risk as compared to domestic firms. A matter of great concern for the international firms is to analyze the implications of the changes in interest rates, inflation rates and exchange rates on their decisions and minimize the foreign exchange risk. The importance of the study is to know the features of foreign exchange and the factors creating risk in foreign exchange transactions and the techniques used for managing that risk.

SAMPLE SIZE In this study the sample size is taken in the form of income statement of company for the year march 2006-2007.

DATA COLLECTION SOURCES OF DATA

The data has been collected from various secondary sources like books and internet.

The data has been collected online with the objectives of the study.

The presentation of study of the IT company provide an insight in knowing the foreign exchange risk policies adopted by them. This data has been collected from the 20062007 annual reports of the companies.

Conclusions have been drawn after the detailed study of the risk management policies of the IT company as to know what are the most widely used hedging instruments for minimizing foreign exchange risk.

METHODOLOGY



The total revenues of the income statements are converted from USA $ to Indian rupee.



The revenues of the companies are divided into 40:60.



The rates which are used for the study are taken as mid value i.e., is Rs.41 and it is compared with minimum & maximum exchange rates.

TABULATION OF DATA DATA ANLAYSIS AND INTREPRETATION HCL

(table .1) DATA ANALYSIS Table:1 CURRENCY EXCHANGE BETWEEN TWO RATES PROFIT&LOSS A/C FOR THE YEAR ENDED JUNE 2007

Particulars

(Rs.in corers)

Income and Expenses@ 60% from foreign (In dollars) Average Exchange rate @Rs.41

If the Exchange rate@41

If the Exchange rate@40

INCOME Net operating Income

3768.62

2261.17

2261.17

2206.02

EXPENSES Material consumption Manufacturing expenses Personal expenses Selling Expenses Administrative Expenses Capitalized Expenses Cost of Sales Reported PBDIT Other recurring income Adjusted PBDIT Depreciation Other write offs Adjusted PBIT Financial expenses Adjusted PBT Tax Charges Adjusted PAT Non recurring-items

0 577.24 1322.59 17.82 913.89 0 2831.54 937.08 16.07 953.15 178.21 0 774.94 20.6 754.34 75.87 678.47 423.35

0.00 346.34 793.55 10.69 365.55 0.00 1516.14 745.03

0.00 346.34 793.55 10.69 365.55 0.00 1516.14 745.03 9.64 754.67 106.93 0.00 647.75 12.36 635.39 45.52 589.87 254.01

0.00 337.89 774.20 10.43 356.63 0.00 1479.16 726.86 9.40 736.26 104.31 0.00 631.95 12.06 619.89 44.41 584.26 247.81

Other non cash Adjustments

0

0.00

0.00

Reported PAT

1101.82

843.88

823.30

GRAPH: 1

2500 2000 1500

If the Exchange rate@41 If the Exchange rate@40

1000 500 0 1

3

5

7

9 11 13 15 17 19 21 23

INTERPRETATION: This graph showing total revenues are alteration together, total revenues are decreased Rs.2261.17 crores to 2206.02, and gross profit also decreased Rs.745.03 to 726.86.simultaneously all these values are changing the net income. If the Exchange rate had fixed @ Rs.41, the revenues would have been same.

HCL (table .2) DATA ANALYSIS Table:2 CURRENCY EXCHANGE BETWEEN TWO RATES PROFIT&LOSS A/C FOR THE YEAR ENDED JUNE 2007

Particulars

(Rs.in corers)

Income and Expenses@ 60% from foreign (In dollars) Average Exchange rate @Rs.41

If the Exchange rate@41

If the Exchange rate@39

INCOME Net operating Income

3768.62

2261.17

2261.17

2150.87

EXPENSES Material consumption Manufacturing expenses Personal expenses Selling Expenses Administrative Expenses Capitalized Expenses Cost of Sales Reported PBDIT Other recurring income Adjusted PBDIT Depreciation Other write offs Adjusted PBIT Financial expenses Adjusted PBT Tax Charges Adjusted PAT Non recurring-items

0 577.24 1322.59 17.82 913.89 0 2831.54 937.08 16.07 953.15 178.21 0 774.94 20.6 754.34 75.87 678.47 423.35

0.00 346.34 793.55 10.69 365.55 0.00 1516.14 745.03

0.00 346.34 793.55 10.69 365.55 0.00 1516.14 745.03 9.64 754.67 106.93 0.00 647.75 12.36 635.39 45.52 589.87 254.01

0.00 329.45 754.84 10.17 347.72 0.00 1484.99 708.69 9.17 717.86 101.71 0.00 616.15 11.76 604.40 43.30 561.10 241.62

Other non cash Adjustments

0

0.00

0.00

Reported PAT

1101.82

843.88

802.72

GRAPH: 2

2500 2000 1500

If the Exchange rate@41 If the Exchange rate@39

1000 500 0 1

3

5

7

9 11 13 15 17 19 21 23

INTERPRETATION: This graph showing total revenues are alteration together, total revenues are decreased Rs.2261.17 to 2150.87, and gross profit also decreased Rs.745.03 to 708.69.simultaneously all these values are changing the net income. If the Exchange rate had fixed @ Rs.41, the revenues would have been same.

HCL (table .3)

DATA ANALYSIS

Table:3 CURRENCY EXCHANGE BETWEEN TWO RATES PROFIT&LOSS A/C FOR THE YEAR ENDED JUNE 2007

Particulars

(Rs.in crores)

Income and Expenses@ 60% from foreign (In dollars) Average Exchange rate @Rs.41

If the Exchange rate@41

If the Exchange rate@42

INCOME Net operating Income

3768.62

2261.17

2261.17

2316.32

EXPENSES Material consumption Manufacturing expenses Personal expenses Selling Expenses Administrative Expenses Capitalized Expenses Cost of Sales Reported PBDIT Other recurring income Adjusted PBDIT Depreciation Other write offs Adjusted PBIT Financial expenses Adjusted PBT Tax Charges Adjusted PAT Non recurring-items

0 577.24 1322.59 17.82 913.89 0 2831.54 937.08 16.07 953.15 178.21 0 774.94 20.6 754.34 75.87 678.47 423.35

0.00 346.34 793.55 10.69 365.55 0.00 1516.14 745.03

0.00 346.34 793.55 10.69 365.55 0.00 1516.14 745.03 9.64 754.67 106.93 0.00 647.75 12.36 635.39 45.52 589.87 254.01

0.00 354.79 812.90 10.95 374.47 0.00 1553.12 763.20 9.88 773.08 109.54 0.00 663.55 12.66 650.89 46.63 24774.71 260.21

Other non cash Adjustments

0

0.00

0.00

Reported PAT

1101.82

843.88

864.46

GRAPH: 3

2500 2000 1500

If the Exchange rate@41 If the Exchange rate@42

1000 500 0 1

3

5

7

9 11 13 15 17 19 21 23

INTERPRETATION: This graph showing total revenues are alteration together, total revenues are increased Rs.2261.17 crores to 2316.3, and gross profit also decreased Rs.745.03 to 763.20.simultaneously all these values are changing the net income. If the Exchange rate had fixed @ Rs.41, the revenues would have been same.

HCL (table .4)

DATA ANALYSIS Table:4 CURRENCY EXCHANGE BETWEEN TWO RATES PROFIT&LOSS A/C FOR THE YEAR ENDED JUNE 2007

Particulars

(Rs.in crores)

Income and Expenses@ 60% from foreign (In dollars) If the Average If the Exchang Exchange rate Exchange e @Rs.41 rate@41 rate@43

INCOME Net operating Income

3768.62

2261.17

2261.17

2371.47

EXPENSES Material consumption Manufacturing expenses Personal expenses Selling Expenses Administrative Expenses Capitalized Expenses Cost of Sales Reported PBDIT Other recurring income Adjusted PBDIT Depreciation Other write offs Adjusted PBIT Financial expenses Adjusted PBT Tax Charges Adjusted PAT Non recurring-items

0 577.24 1322.59 17.82 913.89 0 2831.54 937.08 16.07 953.15 178.21 0 774.94 20.6 754.34 75.87 678.47 423.35

0.00 346.34 793.55 10.69 365.55 0.00 1516.14 745.03

0.00 346.34 793.55 10.69 365.55 0.00 1516.14 745.03 9.64 754.67 106.93 0.00 647.75 12.36 635.39 45.52 589.87 254.01

0.00 363.23 832.26 11.21 383.38 0.00 1590.10 781.37 10.11 791.48 112.15 0.00 679.35 12.96 666.38 47.74 618.64 266.40

Other non cash Adjustments

0

0.00

0.00

Reported PAT

1101.82

843.88

885.04

GRAPH: 4

2500 2000 1500

If the Exchange rate@41 If the Exchange rate@43

1000 500 0 1

3

5

7

9 11 13 15 17 19 21 23

INTERPRETATION: This graph showing total revenues are alteration together, total revenues are increased Rs.2261.17 crores to 2371.47, and gross profit also decreased Rs.745.03 to 781.37.simultaneously all these values are changing the net income. If the Exchange rate had fixed @ Rs.41, the revenues would have been same. The rupee-dollar Exchange rates over the last five years GRAPH.5 Rates 49 48 47 46 45 44

Rates

43 42 41 40 1998

2000

2002

2004

2006

2008

TECHNIQUES AND TOOLS USED TOOLS FOR FOREIGN EXCHANGE RISK MANAGEMNT

Forward exchange contract A forward exchange contract is a mechanism by which one can ensure the value of one currency against another by fixing the rate of exchange in advance for a transaction expected to take place at a future date.

Forward exchange rate is a tool to protect the exporters and importers against exchange risk under foreign exchange contract, two parties one being a banker compulsorily in India, enter into a contract to buy or sell a fixed amount of foreign currency on a specific future date or future period at a predetermined rate. The forward exchange contracts are entered into between a banker and a customer or between two bankers.

Indian exporter, for instance instead of grouping in the dark or making a wild guess about what the future rate would be, enter into a contract with his banker immediately. He agrees to sell foreign exchange of specified amount and currency at a specified future date. The banker on his part agrees to buy this at a specified rate of exchange is thus assured of his price in the local currency. For example, an exporter may enter into a forward contract with the bank for 3 months deliver at Rs.49.50. This rate, as on the date of contract, is known as 3 month forward rate. When the exporter submits his bill under the contract, the banker would purchase it at the rate of Rs.49.50 irrespective of the spot rate then prevailing.

When rupee was devaluated by about 18% in July 1991, many importers found their liabilities had increased overnight. The devaluation of the rupee had effect of appreciation of foreign currency in terms of rupees. The importers who had booked forward contracts to cover their imports were a happy lot.

Date of delivery

According to Rule 7 of FEDAI, a forward contract is deliverable at a future date, duration of the contract being computed from the spot value date of the transaction. Thus, if a 3 months forward contract is booked on 12th February, the period of two months should commence from 14th February and contract will fall on 14th April.

Fixed and option forward contracts The forward contract under which the delivery of foreign exchange should take place on a specified future date is known as ‘Fixed Forward Contract’. For instance, if on 5th March a customer enters into a three months forward contract with his bank to sell GBP 10,000, it means the customer would be presenting a bill or any other instrument on 7th June to the bank for GBP 10,000. He cannot deliver foreign exchange prior to or later than the determined date.

Forward exchange is a device by which the customer tries to cover the exchange risk. The purpose will be defeated if he is unable to deliver foreign exchange exactly on the due date. In real situations, it is not possible for any exporter to determine in advance the precise date. On which he is able to complete shipment and present document to the bank. At the most, the exporter can only estimate the probably date around which he would able to complete his commitment.

With a view to eliminate the difficulty in fixing the exact date of delivery of foreign exchange, the customer may be given a choice of delivery the foreign exchange during a given period of days.

An arrangement whereby the customer can sell or buy from the bank foreign exchange on any day during a given period of time at a predetermined rate of exchange is known as ‘Option Forward Contract’. The rate at which the deal takes place is the option forward sale contract with the bank with option over November. It means the customer can sell foreign exchange to the bank on any day between 1s to 30th November is known as the ‘Option Period’.

Forward contract is an effective ad easily available tool for covering exchange risk. New instruments like options, futures and swaps can also be used to cover exchange risks. These instruments are called financial derivatives as their value is derived from the value of some other financial contract or asset. When there instrument are bought or sold for covering exchange risk they are used for ‘hedging’ the exchange risk. When they are dealt in with a view to derive profit from unexpected movements in their prices or other changes in the exchange market, they are being used for speculative purposes. The scope of using these instruments for speculative purposes is very much limited in India. Some other Strategies may also be adapted to avoid exchange risk. These consist in deciding on the currency of invoicing, maintaining in foreign currency and deciding on the setting the debt.

CHAPTER NO.3 REVIEW OF LITERATURE introduction

Currency exposure management being important in the context of global trade and investments, voluminous literature on the subject is available worldwide. Developed economies account for a big chunk of empirical literature on currency exposure management for obvious reasons. Some literature is available relating to emerging and developing economies also, which may be of greater help to the present research. To facilitate a better review of literature, studies conducted abroad are presented first followed by studies conducted in India. The following is an exhaustive list of investigations conducted in foreign countries. Literature Review The purpose of this chapter is to explain the theoretical underpinnings of foreign exchange risk and exposure, discusses the importance, necessity of foreign exchange risk management, irrelevance theories of exchange rate risk, and measurement of exposures within the theory of the foreign exchange risk management, viz., identifying exposure, establishing policy and employing appropriate techniques, which are essential in providing the basic knowledge to comprehend the issues investigated analyses and the empirical evidence pertaining to foreign exchange risk. 2.1 Nature of Foreign Exchange Risk Risk exists when the future is unknown or when the actual outcomes deviate from the expected outcomes. Foreign exchange risk also known as currency risk is one of the market risks, which is faced by a company that has its operations in more than one country. With regard to foreign exchange risk, risk exists if and only if, when the actual change deviates from the expected change in the foreign currency value. A multinational company has an exposure to foreign exchange risk when the values of its assets or liabilities change with unexpected change in the foreign currency values. Exposure is the amount, which is at risk. In the International Finance literature, though the two terms foreign exchange risk and foreign exchange exposure are being used synonymously, there exists a slight difference between the two. Meaning of Risk Risk in the widest sense is not new to business. The term risk has various definitions. Risk is defined as the volatility of unexpected outcomes, which can represent the value of assets, equity or earnings (Jorion, 2010, p.3). According to Dun & Bradstreet, risk is defined as any event or possibility of an event which can impair corporate earnings or cash flows over short/medium/long-term horizon. In the literature of investment management, risk is defined as the standard deviation around the expected return (Jordon & Fischer, 2000, p.560). In financial management, the term risk refers to the dispersion of a variable, which can be commonly measured by the variance or the standard deviation (Chandra, 1998, p.69) and it is also referred to a situation where the probability distribution of the cash

flow of an investment proposal is known (Pandey,2004, p.245). Risk exists whenever actual outcomes can differ from expectations (Butler,2002, p.8). Therefore, the term risk used in the study refers to a situation where outcomes are uncertain that may lead to losses. Foreign Exchange Risk: One type of Financial Risks Firms are exposed to various types of risks, which can be classified broadly into business and financial risks. Business risks are those which the corporation assumes willingly to create a competitive advantage and add a value for shareholders. On the other hand, financial risks relate to possible losses owing to financial market activities (Jorion, 2010, p.3-4). Business risk is the risk of the firm’s operating cash flows, measured by the standard deviation of earnings before interest and taxes (Butler, 2002, p.422). One more important risk which arises from cross-border operations is country risk. Country risk arises due to unexpected change in host country’s business environment. It includes the uncertainties of dealing with an unfamiliar culture, unexpected changes in the local social or political climate, and unexpected changes in government regulation, financial upheavals, or natural disasters that affect the country’s social, economic, political or financial landscape. 20 Country risk has two important dimensions – political risk and financial risk. Political risk is the risk that the business environment in a host country will change unexpectedly due to political events. The main sources of political risk include unexpected changes in the operating environment arising from repatriation restrictions, taxes, local content regulations, restrictions on foreign ownership, business and bankruptcy laws, foreign exchange controls, and expropriation. Financial risk refers more generally to the risk of unexpected change in the financial or economic environment of a host country. An important financial risk exposure for the multinational corporation is currency risk or foreign exchange risk. Foreign exchange risk is the risk of unexpected change in currency values can affect the value of the corporation’s assets or liabilities (Butler, 2002, p.8). It is no surprise that the concern of corporate management with foreign exchange risk has recently intensified. (Hekman, 1981) Therefore, Indian software companies which are mostly export-oriented are concerned about the risk arising from adverse movements of currency values, which is commonly known as currency risk or foreign exchange risk forms the main focus of this study. Foreign Exchange Risk and Exposure In the literature of international financial management, foreign exchange risk and exposure are two important concepts. It is not uncommon to find the terms exposure and risk being used interchangeably. However, the terms exposure and risk are conceptually and even dimensionally completely different (Levi, 2009, p.285). Levi explains foreign exchange risk is related to the variability of domestic currency values of assets or liabilities due to unanticipated changes in exchange rates, whereas foreign exchange exposure is the amount that is at risk. Foreign exchange risk reflects both the exposure and the range of potential exchange rate variability (Hekman, 1981). Moreover, risk exists when

the future is unknown that is, when actual outcomes deviate from expected outcomes. With regard to foreign exchange rates, an expected devaluation of foreign 21 currency does not constitute risk. Risk exists if the actual devaluation of foreign currency deviates from the expected devaluation. Therefore, currency risk or foreign exchange risk exists if and only if the actual amount of a currency appreciation or depreciation is unknown (Butler, 2002, p.110). Adler and Dumas defined Foreign Exchange Exposure as “The sensitivity of changes in the real domestic currency value of assets or liabilities to changes in exchange rates”. (Adler and Dumas, 1984). Levi (2009, p.286) defined foreign exchange exposure, akin to Adler and Dumas (1984), as the “sensitivity of changes in the real domestic currency value of assets or liabilities to changes in exchange rates”. In this definition, there are several points which are worth noting. Some of the features of this definition are worth noting. i) Exposure is a measure of the sensitivity of domestic currency values. Therefore, it is a description of the extent or degree to which the home currency value of something is changed by exchange rate changes. Exposure takes the form: If this ratio is zero, there is no exposure to the exchange rate. In other words, exchange rates do not change rupee values. The bigger is the absolute value of this ratio, the larger is the exposure to the USD from Indian rupee perspective. ii) Exposure is concerned with real domestic currency values. It means that exposure is inflation adjusted values of assets or liabilities which are sensitive to changes in exchange rates. Therefore, on a same asset or liability, exposure varies depending on the inflation rate prevailing in a particular country. 22 iii) Exposure exists on balance sheet items such as assets or liabilities. There are many ways that the value of assets and liabilities can be affected by exchange rates. Apte (2006) explained exposure as “a measure of the sensitivity of the value of a financial item (asset, liability or cash flow) to changes in the relevant risk factor while risk is a measure of the variability of the value of the item attributable to the risk factor”. These explanations have clarified the difference between the terms foreign exchange risk and exposure. A multinational company is concerned more about foreign exchange exposure, which is created due to increased volume of crossborder transactions rather than the foreign exchange risk, which arises due to variability in exchange rates. Therefore, throughout this study the term risk and exposure has been used interchangeably. Taxonomy of Exposures to Foreign Exchange Risk The firm operating in the international environment will be affected by changes in the exchange rate between different currencies. The degree to which a firm is affected by such changes is called foreign exchange exposure. Traditionally, foreign exchange exposure is divided into transaction, translation and economic exposures (Booth, 1982). Transaction Exposure: Refers to potential changes in the value of contractual or monetary cash flows as a result of unexpected changes in currency values. (Butler, 2002, p.112).

Translation Exposure: Refers to potential changes in financial accounting statements as a result of changes in currency values. (Butler, 2002, p.113 Economic Exposure: Refers to potential changes in all future cash flows due to unexpected changes in exchange rates. (Butler, 2002, p.111). In other words, it includes the impact of unexpected currency changes on contractual transactions as well as on the uncertain future cash flows generated by the firm’s income-producing real assets. Irrelevance Theories of Exchange Rate Risk The starting point for this discussion is a famous analysis by Franco Modigliani and Merton Miller laid out in 1958, which shows that the value of a firm cannot be changed merely by means of financial transactions. The argument assumes that financial markets are “perfect” in the sense that they are highly competitive and that participants are not subject to transaction costs, commissions, contracting and information costs or taxes. This is Modigliani and Miller’s famous irrelevance proposition. Therefore, if financial markets are perfect, then corporate financial policy is irrelevant. Because of equal access to perfect financial markets, the firm’s financial policies and strategies become irrelevant i.e., investors can always create “homemade” financial transactions that are equivalent to anything the firm can create. The value of a firm is then solely determined by the value of expected future investment cash flows (Butler, 2002, p.329). Modigliani and Miller reasoned that whatever the firm can accomplish in the financial markets, the individual investor in the firm can also accomplish on the same terms and conditions. According to capital asset pricing model developed by William Sharpe in 1964, argues that in a world with perfect capital markets, firms should not worry about the risks that are specific to them and should base their investment decisions only on the risks that they hold in common with other companies, because all specific risks are diversified away in the investors’ portfolios, and under the perfect capital markets assumption, this diversification is assumed to be costless. Purchasing Power Parity Argument According to purchasing power parity theory, exchange rate movements are just a response to differentials in price changes between countries. Therefore, the exchange rate effect is offset by the change in prices. PPP does not necessarily hold, however, so the exchange rate will not necessarily change in accordance with the inflation differential between the two countries. Since a perfect offsetting effect is unlikely, the firm’s competitive capabilities may indeed be 24 influenced by exchange rate movements. Even if PPP did hold over a very long period of time, this would not comfort managers of MNCs that are focusing on the next year or even the next five years. 2.3.2 The Investor Hedge Argument The investor hedge argument assumes that investors have complete information on corporate exposure to exchange rate fluctuations as well as the capabilities to correctly insulate

their individual exposure. To the extent that investors prefer that corporations perform the hedging for them, exchange rate exposure is relevant to corporations . Currency diversification Argument Another argument is that if an MNC is well diversified across numerous countries, its value will not be affected by exchange rate movements because of offsetting effects. It is naïve, however, to presume that exchange rate effects will offset each other just because an MNC has transactions in many different countries Stakeholder Diversification Argument Some critics also argue that if stakeholders are well diversified, they will be somewhat insulated against losses experienced by an MNC due to exchange rate risk. Because creditors can experience large losses if the MNCs to which they have extended loans experience financial problems, they may prefer that the MNCs maintain low exposure to exchange rate risk. Consequently, MNCs that hedge their exposure to risk may be able to borrow funds at a lower cost. Necessity of Foreign Exchange Risk Management Corporations engaged in international operations continuously bother to hedge its exposure to foreign exchange risk because hedging creates value by reducing the risk of assets exposed to currency fluctuations. Corporate risk hedging, to add value to an MNC, must either increase the firm’s expected future cash flows or reduce the risk of these cash flows in a way that cannot be replicated by individual investors in the firm and if risk hedging has no value in a perfect financial market, then one of the necessary conditions for corporate hedging to have value is the existence of financial market imperfections that is, if corporate hedging policy is to have value, then at-least one of the MM assumptions cannot hold. Market imperfections create incentives to hedge on the part of one or more of the firm’s stakeholders. The value that can be added by hedging financial price risk depends on the extent of the imperfections. (Nance et al, 1993). The existence of financial market imperfections is a necessary condition for corporate risk hedging to have value. (Berkman and Bradbury, 1996). Share holder value maximization hypothesis predicts that a firm will engage in risk management policies, if and only if, they enhance the firm’s value and thus its shareholders’ value (Fatemi and Luft, 2002). According to Smith and Stulz, hedging can lead to firm value maximization by limiting deadweight losses of bankruptcy (Purnanandam, 2008). The three market imperfections that affect the corporation’s hedging policy and risk management strategies are: i) Tax Schedule Convexity: Tax schedules are said to be convex when the effective tax rate is greater at high levels of taxable income than at low levels of taxable income. In the presence of a convex tax schedule, corporations can reduce their expected tax payment by reducing the variability of investment outcomes. Progressive taxation1 and tax preference items2 contribute to convexity in national tax schedules. ____________________ 1 Progressive tax is a tax system in which larger taxable incomes

receive a higher tax rate. 2 Tax preference items are tax-loss carry-forwards and carry-backs and investment tax credits that are used to shield corporate taxable income from taxes. ii) Costs of Financial Distress: Costs of financial distress can be direct or indirect. Direct costs of financial distress can be directly observed during bankruptcy, liquidation or reorganization proceedings and include attorney and court fees for settling the various claims on the firm’s remaining assets. Indirect costs cannot be measured and classified easily and includes the cost of lost credibility in the market place and various forms of stakeholder gamesmanship that accompany financial distress. As the expected costs of financial distress rise, debt holders require higher interest rates to compensate for these additional risks. If the variability of firm value can be reduced through hedging, then debt can be raised at lower cost and with fewer restrictions in the debt covenants. With lower and less restrictive financial costs, more value can be left over for equity. Therefore, a properly conceived and executed hedging policy can increase the value of both debt and equity by avoiding the costs of financial distress. iii) Stakeholder game-playing: arises from conflicts of interest among the firm’s stakeholders and detracts firm value. During financial distress, debt holders and equity holders shift their focus from value maximization to end-game strategies that maximize their claim over the firm’s diminishing resources. Debt-holders wants to preserve the value of its claim on the firm’s assets, whereas equity holders want to increase the value of its call option, even this is at the expense of debt-holders. Measurement of Exposure As exchange rates cannot be forecasted with perfect accuracy, but the firm can at least measure its exposure to exchange rate fluctuations. If the firm is highly exposed to exchange rate fluctuations, it can consider techniques to reduce its exposure. A firm should first measure its exposure before it chooses techniques to manage foreign exchange exposure. Exposure is measured by the systematic tendency3 for ∆V (INR) to change with respect to ∆Su (Rs/$). The relationship between these two variables can be expressed as: ∆Vt=β∆Su t( Rs/$) + μt The term β is the regression coefficient or slope and describes the sensitivity of the systematic relation between unanticipated changes in exchange rates [∆Su t (Rs/$)] and changes in rupee values of assets or liabilities [∆Vt]. Therefore, foreign exchange exposure is the slope of the regression equation which relates changes in the real domestic currency value of assets or liabilities to unanticipated changes in exchange rates. In the words of Maurice D Levi about foreign exchange risk measurement “Foreign exchange risk is measured by the standard deviation of domestic currency values of assets or liabilities attributable to unanticipated changes in exchange rates”. ______________________ 3 Systematic tendency means the way the variables are on average related to each other. Measuring Transaction Exposure Measuring transaction exposure involves two steps: i) Determination of the projected net amount of inflows or outflows in each foreign currency,

and ii) Determination of the overall risk of exposure to those currencies. An MNC needs to project the consolidated net amount in currency inflows or outflows for all its subsidiaries, categorized by currency. One foreign subsidiary may have inflows of a foreign currency while another has outflows of that same currency. In that case, the MNCs net cash flows of that currency overall may be negligible. If most of the MNCs subsidiaries have future inflows in another currency, however, the net cash flows in that currency could be substantial. Estimating the consolidated net cash flows per currency is a useful step when assessing a MNCs exposure because it helps to determine the MNCs overall position in each currency. Therefore, the first step when assessing transaction exposure is to determine the size of the position in each currency. The second step is to determine how each individual currency position could affect the firm by assessing the standard deviations and correlations of the currencies. Even if a particular currency is perceived as risky, its impact on the firm’s overall exposure will not be severe if the firm has taken only a minor position in that currency. For this reason, both of these steps must be considered when developing an overall assessment of the firm’s transaction risk. A related method for assessing exposure is the value-at-risk (VaR) method, which incorporates volatility and currency correlations to determine the potential maximum one-day loss on the value of positions of an MNC that is exposed to exchange rate movements. Measuring Translation Exposure An MNC creates its financial statements by consolidating all of its individual subsidiaries’ financial statements. A subsidiary’s financial statement is normally measured in its local currency. To be consolidated, each subsidiary’s financial statement must be translated into the currency of the MNCs parent. Since exchange rates change over time, the translation of the subsidiary’s financial statement into a different currency is affected by exchange rate movements. In particular, subsidiary earnings translated into the reporting currency on the consolidated income statement are subject to changing exchange rates. There were arguments against translation exposure. However, the relevance of translation exposure can be argued based on a cash flow perspective or a stock price perspective. Cash Flow Perspective: Translation of financial statements for consolidated reporting purposes does not by itself affect an MNC’s cash flows. Therefore, translation exposure is not relevant. MNCs could argue that the subsidiary earnings do not actually have to be converted into the parent’s currency. Therefore, if a subsidiary’s local currency is currently weak, the earnings could be retained rather than converted and sent to the parent. The earnings could be reinvested in the subsidiary’s country if feasible opportunities exist. If an MNC’s subsidiary remits a portion of the earnings to its parent, however, a weak foreign currency adversely affects cash flows. Even if the subsidiary does not plan to remit any earnings today, it will remit earnings at some point in the future. To the extent that today’s spot rate serves as a forecast of the spot rate that will exist when earnings are remitted, a weak foreign

currency today results in a forecast of a weak exchange rate at the time that the earnings are remitted. In this case, the expected future cash flows are affected by the prevailing weakness of the foreign currency. Stock Price Perspective: Many investors tend to use earnings when valuing firms, either by deriving estimates of expected cash flows from previous earnings or by applying a price-earnings ratio to expected annual earnings to derive a value per share of stock. Since an MNC’s translation exposure affects its consolidated earnings, it can affect the MNC’s valuation. Translation exposure is relevant for three reasons: i) Some MNC subsidiaries may want to remit a portion of their earnings to their respective parents now, ii) the prevailing exchange rates may be used to forecast the expected cash flows that will result from future remittances by subsidiaries, and iii) many investors’ use consolidated earnings to value MNCs. An MNC’s degree of translation exposure is dependent on proportion of its business conducted by foreign subsidiaries, the greater the percentage of an MNC’s business conducted by its foreign subsidiaries, the larger the percentage of a given financial statement item that is susceptible to translation exposure, location of foreign subsidiaries, the locations of the subsidiaries can also influence the degree of translation exposure because the financial statement items of each subsidiary are typically measured by the home currency of the subsidiary’s country and lastly accounting methods, an MNC’s degree of translation exposure can be greatly affected by the accounting procedures it uses to translate when consolidating financial statement data. Translation exposure is simply the difference between exposed assets and exposed liabilities. The traditional concept of exchange risk management is based on reducing accounting or balance sheet exposure. The basic hedging strategy for reducing accounting exposure involves increasing hard currency4 assets and decreasing soft currency assets, while simultaneously decreasing hard currency liabilities and increasing soft currency5 liabilities. (Shapiro and Rutenberg, 1976). ____________________ 4 hard currency refers to a currency which remains unchanged and consistent. 5 soft currency refers to a currency which is expected to fluctuate erratically or depreciate against other currencies. The four principal translation methods are: 1. The Current or Non-Current Method: The underlying theoretical basis of this method is maturity. According to this method, all the foreign subsidiary’s current assets and liabilities are translated into home currency at the current exchange rate. Each noncurrent asset or liability is translated at its historical exchange rate6 . Therefore, a foreign subsidiary with positive local-currency working capital will give rise to a translation loss (gain) from a devaluation (revaluation) with the current or non-current method, and viceversa if working capital is negative. The income statement is translated at the average exchange rate of the period, except for those revenue and expense items associated with noncurrent assets or liabilities. 2. Monetary or Non-monetary Method: This method

differentiates between monetary assets and liabilities7 , that are translated at the current rate and non-monetary assets and liabilities8 , are translated at historical rates. The income statement items are translated at the average exchange rate during the period, except for those revenue and expense items related to nonmonetary assets or liabilities. 3. Temporal Method: This method is a modified version of the Monetary or Non-monetary method except that the inventory is normally translated at the historical rate. However, it can be translated at the current rate if it is shown on the balance sheet at market values. Income statement items are normally translated at an average rate for the reporting period. 4. Current Rate Method: This is the simplest method, where all balance sheet and income items are translated at the current rate except net fixed assets. Under this method, if a firm’s foreign-currency denominated assets exceed its foreign-currency denominated liabilities, devaluation must result in a loss and a revaluation, in a gain. ______________________ 6 historical exchange rate refers to the rates that prevailed on the dates that items were first entered on the balance sheet. 7 monetary assets and liabilities refers to short-term and long term assets and liabilities. 8 non-monetary assets and liabilities refers to real estate and Net worth respectively. Measuring Economic Exposure MNCs should assess the potential degree of exposure that exists and then determine whether to insulate themselves against it. Assessing the economic exposure of an MNC with subsidiaries scattered across countries is difficult, due to the interaction of cash flows denominated in various currencies into, out of, and within the MNC. The overall impact of a given currency’s fluctuation on all of the subsidiaries is extremely complex. Sensitivity of Earnings to Exchange Rates: One method of measuring MNCs economic exposure is to classify the cash flows into different income statement items and subjectively predict each income statement item based on a forecast of exchange rates. Then an alternative exchange rate scenario can be considered and the forecasts for the income statement items revised. By reviewing how the earnings forecast in the income statement changes in response to alternative exchange rate scenarios, the firm can assess the influence of currency movements on its earnings and cash flows. This procedure is especially useful for firms that have more expenses than revenue in a particular foreign currency. Firms with more (less) in foreign costs than in foreign revenue will be unfavorably (favorably) affected by a stronger foreign currency. Firms can also assess their economic exposure over time basing on the developed forecasts of firm’s operating characteristics such as sales, expenses, and exchange rates for several periods ahead and firms economic exposure will be affected by any change in these operating characteristics. Sensitivity of Cash Flows to Exchange Rates: A firm’s economic exposure to currency movements can also be assessed by applying regression analysis to historical cash flows and exchange rate data. PCFt = a0 + a1et + μt Where, PCFt = Percentage change in inflation-adjusted cash flows measured in the firm’s home currency over

period t, et = percentage change in the exchange rate of the currency over period t, μt = random error term, a0 = intercept, a1 = slope coefficient. The regression coefficient a1, estimated by regression analysis, indicates the sensitivity of PCFt to et. If the firm anticipates no major adjustments in its operating structure, it will expect the sensitivity detected from regression analysis to be somewhat similar in the future. 2.6 Foreign Exchange Risk Management Policy As corporations grow beyond their traditional domestic markets and become multinational in scope, they must develop a financial system capable of managing the transactions and the risks of the individual operating divisions and of the corporation as a whole. The treasury division of the multinational corporation fulfills this role, serving as a corporate bank that manages cash flows within the corporation and between the corporation and its external partners. Treasury management has both an internal and external dimension. Internally, treasury must set policies and establish guidelines for how the operating divisions of the firm are to interact with each other. Treasury also must coordinate the interaction of the firm with its various external constituents, including suppliers, customers, banks, creditors, equity investors, and governments. The way that the firm deals with currency risk is a key element of financial policy. Failure to set risk management guidelines and then monitor the corporation’s risk management activities can expose the firm to financial loss or even ruin. Management must decide whether currency risk exposures will be managed, how actively they will be managed, and whether the firm is willing to take speculative positions in the pursuit of its business and financial objectives. Failure to take action in hedging currency risk is a de facto decision to take a speculative position in foreign exchange. Yet the firm may choose to go well beyond a passive posture toward currency risk as it attempts to extract as much value as possible from the firm’s operating cash flows. Risk management requires skills and knowledge, it also requires infrastructure and data acquisition and processing. To Hedge or Not to Hedge: Formulating a Risk Management Policy A risk management strategy that is not carefully structured and monitored is a double-edged sword, that is, if it goes wrong, it can drag a firm down even more quickly than the underlying risk. To ensure that the corporate treasury’s hedging and risk management strategies are consistent with the overall goals of the corporation, top management and must be actively involved in formulating the corporation’s risk management policy and monitoring its implementation. This sounds obvious, but most derivative-related losses result from a failure to follow this simple rule. The multinational corporation must first decide whether it will take a passive or an active approach to hedging its exposures to currency risk. A passive approach does not try to anticipate currency movements, assuming instead that financial markets are informationally efficient. Passive hedging strategies can be applied in a static or in a dynamic manner. A static approach hedges exposures as they are incurred and then leaves these hedges in place until maturity. A dynamic

approach periodically reviews the corporation’s underlying exposures and its currency risk hedges and revises these positions as necessary. Active management also hedges currency risk exposures, but it does so selectively. Hedging policies of MNCs A multinational corporation should not engage in risk management without deciding clearly on its objectives in terms of risk and return. Without clear goals, accepted by the board of directors, management is likely to engage in inconsistent, costly activities to hedge an arbitrary set of risks. In general, hedging policies vary with the MNC management’s degree of risk aversion. An MNC may choose to hedge most of its exposure, to hedge none of its exposure, or to selectively hedge. A policy of always hedging was appreciably more expensive than one of never hedging but taking losses when devaluation occurred. (Shapiro and Rutenberg, 1976). Hedging most of the exposure: Some MNCs hedge most of their exposure so that their value is not highly influenced by exchange rates. MNCs that hedge most of their exposure do not necessarily expect that hedging will always be beneficial. In fact, such MNCs may even use some hedges that will likely result in slightly worse outcomes than no hedges at all, just to avoid the possibility of a major adverse movement in exchange rates. They prefer to know what their future cash inflows or outflows in terms of their home currency will be in each period because this improves corporate planning. A hedge allows the firm to know the future cash flows (in terms of the home currency) that will result from any foreign transactions that have already been negotiated. Hedging none of the Exposure: Multinational companies’ that are well diversified across many countries may consider not hedging their exposure. This strategy may be driven by the view that a diversified set of exposures will limit the actual impact that exchange rates will have on the MNC during any period. Selective Hedging: Many MNCs choose to hedge only when they expect the currency to move in a direction that will make hedging feasible. In addition, these MNCs may hedge future receivables if they foresee depreciation in the currency denominating the receivables. Selective hedging implies that the MNC prefers to exercise some control over its exposure and makes decisions based on conditions that may affect the currency’s future value. Stulz argued that in a world characterized by asymmetric information and transaction costs, shareholder risk management will not be a perfect substitute for corporate risk management and that firms will be forced to bear business or operational risk. This risk becomes tolerable if the firm enjoys a competitive advantage over its rivals within the industry. Therefore, when the firm enjoys a favorable position in the credit markets, commodity markets, or the foreign exchange markets, it will engage in selective hedging strategies in order to avoid the lower tail outcomes, while attempting to capture the benefits of the upper tail outcomes (Fatemi and Luft, 2002).

Limitations of Hedging an Uncertain amount Some international transactions involve an uncertain amount of goods ordered and therefore involve an uncertain transaction amount in a foreign currency. Consequently, an MNC may create a hedge for a larger number of units than it will actually need, which causes the opposite form of exposure. Over hedging (hedging a larger amount in a currency than the actual transaction amount) can adversely affect a firm. A solution to avoid over hedging is to hedge only the minimum known amount in the future transaction, since the amount to be received in a foreign currency at the end of a period can be uncertain, especially for firms heavily involved in exporting. MNCs cannot completely hedge all of their transactions. Nevertheless, by hedging a portion of those transactions that affect them, they can reduce the sensitivity of their cash flows to exchange rate movements. The continual hedging of repeated transactions that are expected to occur in the near future has limited effectiveness over the long run. The use of short-term hedging techniques does not completely insulate a firm from exchange rate exposure, even if the hedges are repeatedly used over time. If the hedging techniques can be applied to longer-term periods, they can more effectively insulate the firm from exchange rate risk over the long run. Management of Foreign Exchange Risk The primary goal in foreign exchange risk management is to shelter corporate profits from the negative impact of exchange rate fluctuations (Mathur, 1982). Foreign exchange exposure management begins with the definition and identification of the international firm’s exchange exposure. Foreign exchange management requires a central group that can control the company’s foreign exchange activities and implement a reporting system to gather and disseminate information throughout the organization.(Soenen, 1979). Management of risk and exposure is an extremely important task and the effectiveness with which it is performed can have serious implications for a company’s survival. 37 The task of managing financial risks must be guided by clearly defined objectives. Risk management policy must clearly enunciate the risk-return tradeoff, the target performance indicator(s), the relevant time frame, and the amount and quality of resources the firm is willing to commit to the risk management function. Evolution and implementation of risk management policy cannot be left solely to the treasury, Senior executives in other functional departments must be closely involved at various stages. Further, the treasury staff must work together closely with the accounting and control department since all financial transactions executed by the former have dimensions like settlement, monitoring of positions, credit risks, proper reporting and tax implications which are the domain of the latter. Hence effective risk management success depends upon the existence of structures and systems which facilitate information flows, allocation of responsibility and authority and performance evaluation. Giddy argued that exchange risk management in multinational firms should be a centralized activity because in a world of floating exchange rates, exchange rates follow essentially a “random walk”, that is, in

the long run, it is not possible to forecast more accurately than the market (Giddy, 1977). For multinational corporations with worldwide operations, a critical issue is whether to centralize exposure management or leave it to the individual units in different countries. Centralization offers several advantages: i) It minimizes duplication and permits economies of scale to be exploited in the use of expensive manpower, equipment and other resources. Staff dedicated on a full time basis to manage financial risks develops an in-depth expertise in foreign exchange and other financial markets and instruments. ii) Transaction costs can be minimized by netting intra-corporate payments and offsetting some exposures against each other. Transaction costs can also be reduced by pooling together several buy/sell transactions instead of executing each separately. iii) The overall picture regarding exposures is easily identifiable instead of being diffused throughout the global organization. iv) Managing translation exposure when global consolidation is required can be done more effectively from a centralized location. Centralized exposure management has some disadvantages too. i) The centralized staff may not be able to appreciate the operational constraints and environment of local subsidiaries. ii) The decisions taken by the centralized risk management team would be guided by the total corporate perspective rather than performance of an individual subsidiary but these decisions may have an adverse impact on the reputed performance indicators of the local management. iii) Measurement of hedging performance is a complex issue. The objective of hedging is presumably risk reduction. But except in the case when the firm is extremely risk averse and its policy is to eliminate all the risks that can be eliminated, it is always a question of risk-return tradeoff which is rarely, if ever, made explicit. Techniques to eliminate foreign exchange exposure If an MNC decides to hedge part or all of its foreign exchange exposure, may select any of the available hedging techniques. By selecting a hedging technique, MNCs normally compare the cash flows that would be expected from each technique. The proper hedging technique can vary over time, as the relative advantages of the various techniques may change over time. Hedging techniques can be categorized into external hedging techniques and internal hedging techniques. The ever increasing degree of exchange rates volatility has spurred the creation of new financing and hedging instruments and techniques. The proliferation of these financial innovations has confounded many treasury planners as to the appropriate instrument or technique to be used in resolving a foreign exchange risk management problem (Soenen and Madura, 1991).

External Hedging Techniques The various external techniques available to a company are: 1. Futures Hedge: Currency futures can be used by firms that desire to hedge transaction exposure. A firm that buys a currency futures contract is entitled to receive a specified amount in a specified currency for a stated price on a specified date. To hedge a payment on future payables in a foreign currency, the firm may purchase a currency futures contract for the currency it will need in the near future. By holding this contract, it locks in the amount of its home currency needed to make the payment. A firm that sells a currency futures contract is entitled to sell a specified amount in a specified currency for a stated price on a specified date. To hedge the home currency value of future receivables in a foreign currency, the firm may sell a currency futures contract for the currency it will be receiving. Therefore, the firm knows how much of its home currency it will receive after converting the foreign currency receivables into its home currency. By locking in the exchange rate at which it will be able to exchange the foreign currency for its home currency, the firm insulates the value of its future receivables from the fluctuations in the foreign currency’s spot rate over time. 2. Forward Hedge: Like futures contracts, forward contracts can be used to lock in the future exchange rate at which an MNC can buy or sell a currency. A forward contract hedge is very similar to a future contract hedge, except that forward contracts are commonly used for large transactions, whereas futures contracts tend to be used for smaller amounts. Also, MNCs can request forward contracts that specify the exact number of units that they desire, whereas futures contracts represent a standardized number of units for each currency. Forward contracts are commonly used by large corporations that desire to hedge. Forward contracts are negotiated between the firm and a commercial bank and specify the currency, the exchange rate, and the date of the forward transaction. MNCs that need a foreign currency in the future can negotiate a forward contract to purchase the currency forward, thereby locking in the exchange rate at which they will obtain the currency on a future date. MNCs that wish to sell a foreign currency in the future can negotiate a forward contract to sell the currency forward, thereby locking in the exchange rate at which they sell the currency on a future date. The decision as to whether to hedge a position with a forward contract or to keep it unhedged can be made by comparing the known result of hedging to the possible results of remaining unhedged. By estimating the real cost of hedging payables, which can be used to determine the probability that a forward hedge will be more costly than no hedge. The real cost of hedging measures the additional expenses beyond those incurred without hedging. When the real cost of hedging is negative, this implies that hedging is more favorable than not hedging. The hedge-versus-no-hedge decision is based on the firm’s degree of risk aversion. Firms with a greater desire to avoid risk will hedge their open positions in foreign currencies more often than firms that are less concerned with risk. The real cost of hedging receivables is positive

when hedging results in lower revenue than not hedging 3. Money Market Hedge: It involves taking a money market position to cover a future payables or receivables position. If a firm has excess cash, it can create a short-term deposit in the foreign currency that it will need in the future. If a firm expects receivables in a foreign currency, it can hedge this position by borrowing the currency now and converting it to dollars. The receivables will be used to pay off the loan. 4. Currency Option Hedge: Firms recognize that hedging techniques such as the forward hedge and money market hedge can backfire when a payables currency depreciates or a receivables currency appreciates over the hedged period. In these situations, an unhedged strategy would likely outperform the forward hedge or money market hedge. The ideal type of hedge would insulate the firm from adverse exchange rate movements but allow the firm to benefit from favorable exchange rate movements. Currency options exhibit these attributes. However, a firm must assess whether the advantages of a currency option hedge are worth the price (premium) paid for it. Hedging payables with Currency Call options: A currency call option provides the right to buy a specified amount of a particular currency at a specified price (the exercise price) within a given period of time. Yet, unlike a futures or forward contract, the currency call option does not obligate its owner to buy the currency at that price. If the spot rate of the currency remains lower than the exercise price throughout the life of the option, the firm can let the option expire and simply purchase the currency at the existing spot rate. On the other hand, if the spot rate of the currency appreciates over time, the call option allows the firm to purchase the currency at the exercise price. That is the firm owning a call option has locked in a maximum price (the exercise price) to pay for the currency. It also has the flexibility, though, to let the option expire and obtain the currency at the existing spot rate when the currency is to be sent for payment. Hedging receivables with currency put options: A currency put option provides the right to sell a specified amount in a particular currency at a specified price (the exercise price) within a given period of time. Firms can use a currency put option to hedge future receivables in foreign currencies, since it guarantees a certain price (the exercise price) at which the future receivables can be sold. The currency put option does not obligate its owner to sell the currency at a specified price. If the existing spot rate of the foreign currency is above the exercise price when the firm receives the foreign currency, the firm can sell the currency received at the spot rate and let the put option expire. Apart from these short term external hedging techniques, multinational companies’ which are certain of having cash flows denominated in foreign currencies for several years can attempt to use long-term hedging techniques. Firms that can accurately estimate foreign currency payables or receivables that will occur several years from now can commonly use three techniques to hedge such long-term transaction exposure.

FINDINGS OF THE STUDY

FINDINGS

The company has to hammer out its approach to risk management taking into account its specific circumstances.

Here is brief description of company in India have fashioned its strategy towards foreign exchange risk management.

HCL THCHNOLOGIES HCL Technologies is one of India's leading global IT Services companies, providing software-led IT solutions, remote infrastructure management services and BPO. Having

made a foray into the global IT landscape in 1999 after its IPO, HCL Technologies focuses on Transformational Outsourcing, working with clients in areas that impact and re-define the core of their business. The company leverages an extensive global offshore infrastructure and its global network of offices in 18 countries to deliver solutions across select verticals including Financial Services, Retail & Consumer, Life Sciences & Healthcare, Hi-Tech & Manufacturing, Telecom and Media & Entertainment (M&E). For the quarter ended 30th September 2007, HCL Technologies, along with its subsidiaries had last twelve months (LTM) revenue of US $ 1.5 billion (Rs. 6363 corers) and employed 45,622 professionals.

As its operations in many countries, the company is exposed to currency risk. Here is the description:

1. They transact a major portion of their business in USD and the lesser extent other currencies and is thus exposed to currency risk, The company manages risk on account of foreign currency fluctuations through treasury operations. 2. To mitigate the risk of changes in foreign exchange rates on cash flows denominated in USD, HCL technologies purchases foreign exchange forward contracts and the company does not speculate the currency exchange. 3. Foreign exchange transactions of their revenues were generally in USD. The average exchange rate of INR to USD in fiscal 2007 was Rs.41 against Rs.44 in fiscal 2006.

The above description of risk management in HCL is based on the information provided in the annual report of HCL for the year 2007.

CONCLUSIONS From the above study of foreign exchange market it concluded that the H0(the main hypothesis) is proven and the H1(alternate hypothesis) is proven wrong. therefore by investing in foreign exchange market company can get safe and certain amount of return and hedging is possible under forex market .

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Despite market expansion the profit generation is still a question mark, so companies have to search for areas of next generation like value added services, software enhancement and development other than just BPO services to survive in the market.

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In the present day economies are globalized and the stabilities of them is really at stake, the only rescue for the software companies is to improve their responsiveness to the changing scenarios.

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Companies have to develop their services to the bench mark level or global standards so that they can have acceptance all over the world.

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The troubles of many exporters are not a result of the volatility of the rupee but the unfavorably high-cost structure. Exporters are viable only when foreign exchange earnings get converted into more and more rupees. To improve rupee viability and preserve profits, exporters need to be efficient and productive and bring down aggregate rupee cost.

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Poor viability will not be resolved by hedging. Considering an inefficient exporter, it requires a breakeven exchange rate of Rs.45 dollar to show profit. It will dazzle at a rate above Rs.45. It will fizzle at any exchange rate below Rs.45.

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In case of forward contract. The forward contract locks in the exporter conversion of dollar revenues to rupee revenues at Rs.41, the market forward price per dollar. The market will surely not buy the exporters dollars at Rs.41 will be wholly ineffective exporters will be in serious trouble despite the perfect hedge.

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The problem of viability will be solved only when the exporters breakeven moves down to Rs.41 per dollar. By contrast, an inefficient exporter that is viable at Rs.41 per dollar can take advantage of the hedge.

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The implicit dollar method will significantly preserve the dollar profitability exporters. The employees and managers of exporting firms will be paid implicitly in dollars. The cost to the company will be in dollars. But the payout will be in rupees and at the prevailing exchange rates. If the dollar weakens, the dollar costs of employees and managers will be paid out in rupees at say, RS.39, if the dollar strengthens the cost of employees and managers will be paid out in rupees at say, Rs.43.

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To overcome these problems exporters should make good governance by making available superior human, social and business infrastructure even if the tax rates are high. Good governance lower the costs of operations and lowers the aggregate costs of doing business.

BIBLIOGRAPHY

Websites www.google.com

www.mecklai.com

www.wipro.com

www.infosys.com

www.hcltechnologies.com

BOOKS 1. Foreign Exchange Arithmetic-M.jeevanandam

2. International financial management-Prasanna Chandra

3. International financial management-P.G.Apte

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