INTRODUCTION The importance of international trade in the economy of a country is too well known to require emphasis.

A number of advantages flow from international trade. Many developed nations of the world owe their present status to international trade; many developing countries place their hopes of development on it. A common man, who is not keenly interested in these use a large number of these items are either imported or some components of them are imported. Even if an item is indigenously produced, it may be found that it is made on an imported machine. FOREIGN TRADE AND FOREIGN EXCHANGE 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 exporter and the importer presents certain peculiar problems in the conduct of international trade and settlement of the transactions arising there from. Important among such problems are: 1. Different countries have different monetary units; 2. Restrictions imposed by countries on import and export of goods; 3. Restrictions imposed by nations on payments from and into their countries; and 4. Differences in legal practices in different countries. The existence 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 his own country. For instance, if amerexport of New York export machinery to indimports, mumbai, the former would like to get the payment in US dollars. Payment in Indian rupees will not serve their purpose because Indian rupee cannot be used as currency in the USA. On the other hand, the importers in India have their savings and borrowings in Indian in rupees. Thus the exporter requires payment in the currency of the exporters country whereas the importer can pay only in the currency of the importers country. A need, therefore, arises for conversion of the currency of the importers country into that of the exporters country. Foreign exchange is the mechanism by which the currency of one country gets converted into the currency of another country.

The conversion of currencies is done by banks who deal in foreign exchange. These banks maintain stocks of foreign currencies in the form of balance with banks abroad. For instance, Indian bank may maintain an account with bank of America. New york, in which dollar balances are held,. In the earlier example, if indimports pay the equivalent rupees to Indian bank, it would arrange to pay amerexport at New York in dollars 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. In our illustration, if Indian bank exchanged USD for Indian rupees at Rs. 44 a dollar, the exchange rate between rupee and dollar can be expressed as USD 1 = Rs. 44 The rates in the foreign exchange market are determined by the interaction of the forces of demand and supply are affected by a number of factors, both fundamental and transitory, the rates keep on changing frequently, and violently too. FOREX AS STOCK In another sense, the term foreign exchange is used to refer to the very balance held broad. Used in this sense, the foreign exchange refers to the stock of foreign currencies and other foreign assets. The foreign exchange management act, 1999, defines: Forex means foreign currency and includes1. Deposits, credits and balance payable in any foreign currency, 2. Drafts, travelers cheques, letters of credit or bills of exchange expressed or drawn in Indian currency but payable in any foreign currency; 3. Drafts, travelers cheques, letters of credit or bills of exchange drawn by banks, institutions or persons outside India, but payable in Indian currency. FOREX VS. EQUITIES If you are interested in trading currencies online, you will find that the Forex market offers several advantages over equities trading. 24-Hour Trading

 Superior Liquidity Leverage Lower Transaction Costs Profit Potential In Both Rising And Falling Markets FOREX VS. FUTURES The global foreign exchange market is the largest, most active market in the world. Trading in the forex markets takes place nearly round the clock with over $1 trillion changing hands every day. It is the main event. More Volume = Better Liquidity. Forex markets offer tighter bid to offer spreads than currency futures markets Forex markets offer higher leverage and lower margin rates than those found in currency futures trading. Forex markets utilize easily understood and universally used terms and price quotes. Forex trades executed are commission free. BALANCE OF PAYMENTS (BOP) BOP is a record of all economic transactions between residents of a country with outsiders during a specified time period, normally a year. It constitutes the results of demand for and supply of foreign exchange for various purposes. Since the forces of demand and supply determine the rate of exchange between currencies, BOP is the fundamental factor in determining the exchange rates. A change in the BOP of a country will affect the exchange rate of its currency. Economic transactions: - Arises from 1. Movement of goods in the form of exports and imports; 2. Rendering of services abroad and using foreign services; 3. Gifts/grants from one country to another; 4. Investments made abroad or received from abroad; 5. Income on investments received from abroad or remitted abroad or remitted abroad; 3

6. Increase or decrease in the international reserves of the country. Residents with non-residents Residents include individuals, institutions, corporate bodies, government departments etc., domiciled in the country. Units or branches of multinational companies domiciled in the country are also residents and their transactions with their parent or branches abroad also are reflected in the BOP. If the economic transaction is between residents only, it is not included in the BOP BOP ACCOUNTING In the compilation of the BOP the double entry principle of accounting is used 1. Credit is indicated by the arithmetic sign (+) and represents outflow of real assets (exports) from the country or incurring liability abroad or decrease in the foreign assets. 2. Debit is indicated by the arithmetic sign (-) and represents inflow of real assets (imports) into the country or decrease in foreign liability abroad or increase in foreign assets. The plus sign and minus sign indicate respectively the earning and spending of foreign exchange by the country. COMPONENTS OF BOP 1. Current account 2. Capital account and 3. Official reserves account. Current account The current account of the BOP refers to transaction in goods and services, income and current transfers. In other words, it covers all transactions between residents and nonresidents, other than financial items. It includes 1. Merchandise: - represents exports and imports of commodities from/into India. 2. Invisibles: - includes services, transfers and investment incomes.

Capital account The capital account represents transfer of money and other capital items and changes in the country's foreign assets and liabilities resulting from the transactions recorded in the current account. 1. Foreign investment in India is the amount invested by non-residents in the equity of entitles in India. 2. Loans 3. Commercial borrowings 4. Banking capital 5. Short term credit Overall Balance Balance on capital account is the net of inflows and outflows on capital transactions. It is also appropriate to call this balance on private capital account as this excludes movement in official reserves. Overall balance is the total of balance on current account and balance on capital account. It is also called official settlements balance since it must be financed by official reserves or by other non-reserve transactions that are substitute for reserve transactions Errors and Omissions The sources of debit and credit may vary, the time of recording for each leg of the transaction may also vary. These differences would be shown separately as errors and omissions. INTERNATIONAL EXCHANGE SYSTEMS We saw that the exchange rate between currencies in a foreign exchange market is affected by a number of factors. The extent to which these fluctuations are allowed is vastly dependent on the monetary systems adopted. When countries were under gold standard the value of currency of a country was fixed as the value of gold of definite weight and fineness. The exchange rate between the currencies was determined on the relative value of gold content of currencies concerned. 5 Direct investment Portfolio investment

For example, if the gold content of Indian rupee was 5 grains of standard purity, and that of US dollar 60 grains of standard purity, the rate of exchange between Indian rupee and US dollar could be determined as under: 1 Rupee = 5/60 = USD 0.0833 or, 1 USD = 60/5 = Rs. 12. Exchange rates were stable under gold standard because any deviation in the exchange rate would be set right automatically by the movement of gold between the countries that such deviation caused. When the paper currency system replaced the gold standard, the exchange rate was determined by relative purchasing power of the currencies. The stability in exchange rates gave way to fluctuations with dynamic situation prevailing all round. FIXED AND FLOATING EXCHANGE RATES Fixed Exchange Rates: - refer to the system under the gold standard where the rate of exchange tends to stabilize around the mint par value. In present-day situation where gold standard no longer exists, fixed rates of exchange refer to maintenance of external value of the currency at a predetermined level. Whenever the exchange rate differs from this level it is corrected through official intervention. For example, when IMF was instituted, every member-country was required to declare the value of the currency in terms of gold and US dollars (known as the par value). The actual market rates were allowed to fluctuate only within a narrow band of margin from this level. Floating/Flexible Exchange Rates Free or floating rates refer to the system where the exchange rates are determined by the conditions of demand for and supply of foreign exchange in the market. The rates are free to fluctuate according to the changes in demand and supply forces with no restrictions on buying and selling of foreign currencies in the exchange market. The central bank does not intervene in the market and any disparity in the balance of payments is adjusted through the changes in exchange rate that take place automatically in the market. Flexible rates of exchange refer to the system where the exchange rate is fixed, but is subject to frequent adjustments depending upon the market conditions. Thus, it is not a free or floating rate with cent percent flexibility, but is any system providing for

adjustments as and when required. Advantages of Fixed Exchange Rates 1. Promotion of International Trade - Stable exchange rates providing certainty and confidence. 2. Promotion of International Investment 3. Facility of Long-range Planning 4. Development of Currency Areas - Proper functioning of regional arrangements like sterling area or dollar area would be facilitated with the stable exchange rates 5. Prevention of Speculation 6. Helps Small Open Economies Advantages of Floating Exchange Rates 1. Adjustment of BOP 2. Better liquidity 3. Gains from foreign trade 4. Cost-price relationship 5. Independence of policy. FACTORS DETERMINING FORWARD MARGIN Forward margin refers to the difference between the spot rate and forward rate of a currency, making the forward currency cheaper or costlier as compared to the spot currency. (1) Rate of Interest: The difference in the rate of interest prevailing at the home centre and the concerned foreign centre determines the forward margin. If the rate of interest at the foreign centre is higher than that prevailing at the home centre, the forward margin would be at discount. Conversely, if the rate of interest at the foreign centre is lower than that at the home centre, the forward margin would be at premium. If suitable conditions prevail in the market, the rate of interest would exert a greater influence than any other factor and the forward margin would tend to settle at a rate where the gain/loss in the interest rate differential is fully compensated by the forward margin. (2) Demand and Supply: Forward margin is also determined by the demand for and the supply of foreign currency. If the demand for foreign currency is more than its supply,

forward rate would be at premium. If the supply exceeds the demand, the forward rate would be at discount. Some of the investors who want to gain out of the interest rate may try to borrow from low interest centre and invest in high interest centre. (3) Speculation about Spot Rates: Since the forward rates are based on spot rates, any speculation about the movement of spot rates would influence forward rates also. If the exchange dealers anticipate the spot rate to appreciate, the forward rate would be quoted at premium. If they expect the spot rate to depreciate, the forward rates would be quoted at a discount. These expectations about the spot rates are based on a number of factors. (4) Exchange Regulations Exchange control regulations may put some conditions on the forward dealings and may obstruct the influence of the above factors on the forward margin. Such restrictions may be with respect to keeping of balances abroad borrowing overseas etc. Intervention in the forward market by the central bank may also done to influence the forward margin. FACTORS DETERMINING SPOT EXCHANGE RATES The rate of exchange in the market is the outcome of the combined effect of a multiple of factors constantly at play. (1) Balance of Payments: Balance of payments represents the demand for and supply of foreign exchange, which ultimately determine the value of the currency. Exports, both visible and invisible represent the supply side for foreign exchange. Imports, visible and invisible create demand for foreign exchange. When the balance of payments of a country is continuously at deficit, it implies that the demand for the currency of the country is lesser than its supply. Therefore its value in the market declines and vise versa. (2) Inflation: Inflation in the country would increase the domestic prices of the commodities. With increase in prices exports may dwindle because the price may not be competitive. With the decrease in exports the demand for the currency would also decline; this in turn would result in the decline of external value of the currency. It may be noted that it is the relative rate of inflation in the two countries that cause changes in exchange rates. (3) Interest Rates: The interest rate has a great influence on the short-term movement of capital. When the interest rate at a centre rises, it attracts short- term funds from other

centres. This would increase the demand for the currency at the centre and hence its value. (4) Money Supply: An increase in money supply in the country will affect the exchange rate through causing inflation in the country. It can also affect the exchange rate directly. An increase in money supply in the country relative to its demand will lead to large-scale spending on foreign goods and purchase of foreign investments. Thus the supply of the currency in the foreign exchange markets is increased and its value declines. The downward pressure on the external value of the currency then increases the cost of imports and so adds to inflation. (5} National Income: An increase in national income reflects increase in the Income of the residents of the country. This increase in the income increases the demand for goods in the country. If there is underutilized production capacity in the country, this will lead to increase in production. There is a chance for growth in exports too. But more often it takes time for the production to adjust to the Increased income. Where the production does not increase in sympathy with income rise, 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 and decline in the value of the currency. (6} Resource Discoveries: When the country is able to discover key resources, its currency gains value. A good example can be The discovery of North Sea oil by Britain helped pound-sterling to rise to over USD 2.40 from USD 1.60 in a couple of years. (7} 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 currency will rise. Reverse will happen in case of fall in interest rates. (8} Political Factors: Political stability induces confidence in the investors and encourages capital inflow into the country. This has the effect of strengthening the currency of the country. On the other hand, where the political situation in the country is unstable. It makes the investors withdraw their investments. The outflow of capital from the country would weaken the currency. (9) Psychological Factors and Speculation: In the short run, the exchange rate is affected

mostly by the views of the participants in the market about the likely changes in the exchange rates. These expectations are based on many of the factors listed above. Whenever there is a discrepancy between the previously held expectation of a given factor and actual outcome of it, exchange rates will usually be affected. INTEREST RATE PARITY (IRP) No Arbitrage condition when international financial markets are in equilibrium. Assuming free movement of capital, international financial markets should be efficient. "Smell of profits" eliminates any discrepancies. Covered Interest Rate Parity = Parity conditions in financial markets, when forward markets are used to eliminate or "cover" any FX risk. Example: U.S. investor has $1 to invest for one year. You consider two strategies: 1) Invest in U.S. treasury securities at i $, the domestic interest rate, for one year; or 2) Invest in foreign U.K. treasury securities at i , and hedge FX risk by selling maturity value of s forward one year. In U.S., your payoff (maturity value) in one year will be: $1(1 + i$) In equilibrium this should be the same as your payoff in U.K. In U.K., your investment strategy involves: 1. 2. 3. Sell $1 for s to get 1 / S ($/) pounds. (We assume that S = S ($/)). Invest s at U.K. int. rate (i) with payoff = 1/S x (1 + i) Sell s forward at F 360 ($/) for the maturity value of the UK investment, to get a

guaranteed amount of $s. For either investment, you start and end with U.S. dollars. For Strategy #2, you have completely hedged ("covered") FX risk with the forward contract. The Interest Rate Parity (IRP) condition would be: (1 + i$) = (F / S) (1 + i) IRP is an application of the Law of One Price (LOP) to financial securities, says that two identical securities (e.g. Treasury securities) should have the same return, after accounting for the ex-rates (S and F). We need the F rate here because we have added the time dimension, in this case one year in the future

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TECHNICAL ANALYSIS OF FOREX Technical analysis is a method of forecasting price movements by looking at purely market-generated data. Price data from a particular market is most commonly the type of information analyzed by a technician, though most will also keep a close watch on volume and open interest in futures contracts. The bottom line when utilizing any type of analytical method, technical or otherwise, is to stick to the basics, which are methodologies with a proven track record over a long period. After finding a trading system that works for you, the more esoteric fields of study can then be incorporated into your trading toolbox. The building blocks of any technical analysis system include price charts, volume charts, and a host of other mathematical representations of market patterns and behaviors. Most often called studies, these mathematical manipulations of various types of market data are used to determine the strength and sustainability of a particular trend. So, rather than simply relying on price charts to forecast future market values, technicians will also use a variety of other technical tools before entering a trade. Price charts And Chart patterns There are a variety of charts that show price action. The most common are bar charts. Each bar will represent one period of time and that period can be anything from one minute to one month to several years. These charts will show distinct price patterns that develop over time. Candlestick patterns Point & figure patterns Technical Indicators Trend indicators Strength indicators Volatility indicators Cycle indicators Support/resistance indicators Momentum indicators

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FUNDAMENTAL ANALYSIS OF FOREX Fundamental analysis refers to the study of the core underlying elements that influence the economy of a particular entity. It is a method of study that attempts to predict price action and market trends by analyzing economic indicators, government policy and societal factors within a business cycle framework. If you think of the financial markets as a big clock, the fundamentals are the gears and springs that move the hands around the face. Anyone walking down the street can look at this clock and tell you what time it is now, but the fundamentalist can tell you how it came to be this time and more importantly, what time it will be in the future. Fundamental analysis is a very effective way to forecast economic conditions, but not necessarily exact market prices. For example, when analyzing an economist's forecast of the upcoming GDP or employment report, you begin to get a fairly clear picture of the general health of the economy and the forces at work behind it. However, you'll need to come up with a precise method as to how best to translate this information into entry and exit points for a particular trading strategy. A trader who studies the markets using fundamental analysis will generally create models to formulate a trading strategy. These models typically utilize a host of empirical data and attempt to forecast market behavior and estimate future values or prices by using past values of core economic indicators. This information is then used to derive specific trades that best exploit this information. For forex traders, the fundamentals are everything that makes a country tick. From interest rates and central bank policy to natural disasters, the fundamentals are a dynamic mix of distinct plans, erratic behaviors and unforeseen events. Therefore, it is best to get a handle on the most influential contributors to this diverse mix than it is to formulate a comprehensive list of all "The Fundamentals." There are many different fundamental indicators of currency values released at many different times. Here are a few:

Non-farm Payrolls Purchasing Managers Index (PMI) Consumer Price Index (CPI) Retail Sales

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FOREX RISK MANAGEMENT In these days of reducing spread between the lending and borrowing rates, banks have to look to other sources to improve their bottom lines. Foreign exchange is one area where the potential is vast. The progressive liberalization being introduced in the Indian foreign exchange market has improved the scope for dealers to show their skills and earn for their banks. But, at the same time, it may not be forgotten that any scope for profits is associated with the risks of losing. It is more so in the case of foreign exchange dealing where the vagaries of the market can play havoc. Unbridled enthusiasm has to be monitored so that the bank does not expose itself to unduly huge risks. Risk in Forex Dealing The following are the major risks in foreign exchange dealings: 1. Open Position Risk: refers to the risk of change in exchange rates affecting the overbought or oversold position in foreign currency held by a bank. Hence, this can also be called the rate risk. The risk can be avoided by keeping the position in Foreign Exchange Square. 2. Cash Balance Risk: refers to actual balances maintained in the nostro accounts at the end of each day. Balances in nostro accounts do not earn interest; while any overdraft involves payment of interest. The endeavor should, therefore, be to keep the minimum required balance in the nostro accounts. However, perfection on this count is not possible. Depending upon the requirement for a single currency more than one nostro account may be maintained. Each of these accounts is operated by a large number of branches. Communication delays from branches to the dealer or from the foreign bank to the dealer may result in distortions. The banks endeavour to obtain the statement of accounts from foreign banks on a daily basis through telecommunication and monitor closely the balances in nostro accounts helps in this regard. 3. Maturity Mismatches Risk: This risk arises on account of the maturity period of purchase and sale contracts in a foreign currency not coinciding or matching. The cash flows from purchases and sales mismatch thereby leaving a gap at the end of each period. Therefore, this risk is also known as liquidity risk or gap risk. Mismatches in position may arise out of the following reasons:

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(i) (ii) (iii) (iv)

Under forward contracts, the customers may exercise their option on any day during the month. Non-availability of matching forward cover in the market for the volume and maturity desired. Small value of merchant contracts may not aggregate to the round sums for which cover contracts are available. In the interbank contracts, the buyer bank may pick up the contract on: any day during the option period.

The mismatch can be corrected by undertaking a suitable swap. 4. Credit Risk: is the risk of failure of the counter party to the contract. Credit risk is classified into (a) contract risk, and (b) clean risk. Contract Risk arises when the bank knows the failure of the counter party before it executes its part of the contract. Here the bank also refrains from the contract. The loss to the bank is the loss arising out of exchange rate difference that may arise when the bank has to cover the gap arising from failure of the contract. Clean Risk Arises when the bank has executed the contract, but the counter- party does not. The loss to the bank in this case is not only the exchange difference, but the entire amount already deployed. This arises, because, due to time zone differences between different centres, one currency is paid before the other is received. 5. Country Risk: Also known as 'sovereign risk' or 'transfer risk', country risk relates to the ability and willingness of a country to service its external liabilities, It refers to the possibility that the government as well other borrowers of a particular country may be unable to fulfill their obligations under foreign exchange transactions due to reasons which are beyond the usual credit risks. 6. Overtrading Risk: if the volume of transactions indulged by it is beyond its administrative and financial capacity. In the anxiety to earn large profits, the dealer or the bank may take up large deals, which a normal prudent bank would have avoided. The deals may take speculative tendencies leading to huge losses. 7. Fraud Risk: may be indulged in by the dealers or by other operational staff for personal gains or to conceal a genuine mistake committed earlier. Frauds may take the form of dealing for one's own benefit without putting them through the bank accounts,

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undertaking unnecessary deals to pass on brokerage for a kick back, sharing benefits by quoting unduly better rates to some banks and customers, etc. The losses from such fraudulent deals can be substantial. 8. Operational Risks: These risks include inadvertent mistakes in the rates, amounts and counter parties of deals, misdirection of funds, etc. The reasons may be human errors or administrative inadequacies. The deals are done over telecommunication in and mistakes may be found only when the written confirmations are received later. But reversing such mistakes may involve exchange rate and interest losses for the bank. If nostro reconciliation is not proper, the mistakes may remain undetected for long periods. MEASURE OF VALUE AT RISK (VAR) One aspect of exposure to volatile assets like foreign exchange, shares and derivatives is the total outlay of funds required. The other and more important aspect is the losses likely arise due to volatility in prices. For instance, if a bank has an open position of USD I million acquired at an average cost of Rs.43 per dollar, the total funds outlay would be Rs. 43 crores. Supposing the exchange rate is likely to vary by 50 paise per dollar. The value at risk is Rs. 50 lakhs. It means that the loss likely to arise to the bank for holding dollar balance of USD I million is Rs. 50 lakhs. The loss that is likely to arise due to holding of a volatile asset is known as the value at risk. The likely changes in prices are calculated statistically, based on the trend observed in the past. FEDAI has come out with a VAR model in respect of d foreign exchange exposure for use by its member banks. Difference between Exposure and Risk: The exposure relates to the total value of assets, liabilities or cash flows of an enterprise denominated in foreign currency, while exchange risk relates to the excess or shortfall in the cash flows or value of assets or liabilities likely to arise on account of exchange rate fluctuations. Thus exposure relates to the absolute value of an asset or liability involved, and the risk relates to the changes in the value. It is the exposure that leads to risk, through exchange rate changes. However, it is observed that the term exposure is used in practice to refer to risk also.

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TYPES OF EXPOSURES Three types of exchange exposure are recognized: (i) Transaction or conversion exposure (ii) Translation or accounting exposure (iii) Operating or economic exposure TRANSACTION EXPOSURE Transaction exposure deals with changes in cash flows that result from existing contractual obligations. It refers to the risk associated with the change in the exchange rate between the time an enterprise initiates a transaction and settles it. For example, an exporter may quote a price of USD 10,000 based on exchange rate of Rs. 38 per dollar. He hopes to receive Rs. 3,80,000 on executing the order. If the contract is executed, say, after three months, and the exchange rate rules at Rs. 34 per dollar, the exporter will receive only Rs. 3.40,000 short of his expectations by Rs. 40,000. The rate may turn favorable and the exporter may gain also. However the fact remains that the amount that will be received may not be the same as the amount originally anticipated. It is this uncertainty about the amount to be received on conversion that leads to the transaction exposure. The gain or loss that arises on account of exchange rate fluctuations when the foreign currency denominated transaction is settled and converted into the domestic currency is known as the transaction exposure. Since the gain or loss arises on converting the foreign currency into domestic currency it is also known as conversion exposure. The transactions exposure arises whenever the enterprise has foreign currency denominated receivables payables, may be arising out of sale or purchase or borrowing or investment. The obligations of payment or receipt is entered into by the company before a change in the exchange rate, but settled after the change. The extent of exposure would include all unsettled payables and receivables for which commitments have been made by the enterprise, e.g.. unexecuted customer's orders. MANAGING TRANSACTION EXPOSURE The objective of a company in managing its transaction exposure is to avoid losses that may occur due to exchange rate fluctuations. At the same time to the extent possible it should not forgo likely gains from favorable changes in exchange rates. A company which wants to play safe and avoid totally the risk may go in for hedging each of its exposure. On the other end of the scale

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is a company, which takes active, interest in the study of the rate movements, ventures to speculate and accordingly devises strategies to gain out of the exchange rate movements. Thus, the loss incurred from one position due to exchange rate change is offset or counterbalanced by a profit earned on the opposite position, on account of the same exchange rate change. Following are the methods by which the transaction exposure can be hedged (external hedging methods): (i) (ii) (iii) (iv) Forward contract hedge Money market hedge Options Futures

The other method of managing transaction exposure is to avoid such exposure. In the following cases, transaction exposure is avoided by the company (internal hedging methods): (i) (ii) (iii) (iv) Exposure netting Currency invoicing Foreign currency account Leading and lagging

1. Forward Contract Hedge Forward contract has been most Widely used form of hedging exchange rate risk. In a forward contract, the company arranges for disposing the foreign currency or acquires the foreign currency at a future date, when it is likely to be received or paid by it, at a predetermined exchange rate. Thus, an exporter who has receivable, in US Dollar maturity after 6 months can sell this amount to his bank under a forward contract. On maturity, when the receivable realizes this can be sold to the bank at the forward rate agreed, irrespective of the spot rate prevailing. Similarly, a company, which has a payable in foreign currency, may buy foreign currency from the bank and thus determine in advance its cost in rupees. One measure of cost of hedging through forward contracts is the forward premium or discount, which represents the difference between the spot rate prevailing and the forward rate.

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2. Money Market Hedge This is also known as spot market hedge. Under this method, the company, which has an exposure in a foreign currency, covers it by borrowing or investing the concerned currency in the money market and squares its position on the due date. For Instance. let us say that an importer has to pay USD 1.00.000 after six months. The exchange rate of US Dollar is quoted as follows: He can cover his position is to purchase dollar immediately in the spot market and invest it in money market. The value of dollars invested will be so decided that together with the interest earned, the amount received from the investment at the end of six months will be USD 1.00.000. Assuming an interest of 6% on the investment, the principal required to be invested can be calculated as follows: 1.03 x = USD 1.00.000 x = 97.087.38 (* On USD 1, interest for 6 months is USD 0.03. Therefore. the amount at the end of 6 months is USD 1.03.) At the end of six months, the investment of USD 97.087.38 will become USD 1,00,000 which can be used to pay for the import. For buying USD 97.087 .98 immediately; the company has to pay Rs. 46.60.194 at the spot rate of Rs. 48 per dollar. Either, the importer borrows this amount in the money market paying interest or deploys his own funds in which case, opportunity interest is involved. Assuming the interest for rupee funds is 10%. The amount require to repay the borrowing after six months will be: Principal Rs. 46,60.194 Interest at 10% for 6 months Rs. 2.30.097 Rs. 48.90.291 by covering through money market, the company ends up with a cash outflow of Rs. 48.90.291 as against Rs. 49 lakhs under forward contract. 3. Hedging with Options: Option gives the buyer a right but not an obligation to buy or sell a specified amount of foreign currency on a specified future date. The disadvantage under forward contract is that the hedger cannot take advantage of any favorable changes in the exchange rate movement. For instance an exporter who booked a forward contract for dollars at Rs. 38.00 has to accept the same rate for dollars when he delivers foreign

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exchange to his bank irrespective of the spot rate prevailing. If the spot rate on the date of delivery is Rs. 40. yet the forward contract will be executed at Rs. 38. The hedger therefore, incurs an opportunity loss of Rs. 2 per dollar under the forward contract. Option contract provides an opportunity to the hedger not only to cover this exposure but also to gain from any favorable change in exchange rate. In the situation just narrated. If the exporter had booked option contract at Rs. 38 per dollar he would prefer not to exercise the option. In that case, he can obtain from the bank Rs. 40 per dollar at the spot rate. Thus, option contract helps the hedger to avoid the loss and at the same time enjoy the gains. But option contract is not available without any cost. Premium is paid up-front and is not recoverable whether the option is exercised or not. Therefore, the cost is involved are (i) (ii) (i) (ii) The premium paid and Interest on the premium paid till the execution of the contract. Where the likelihood of the exposure becoming a reality is uncertain. Where the exposure is certain, but the direction the exchange rate will take is uncertain. 4. Hedging with Futures Due to intense competition in the futures market, currency futures are available with this margin. They may prove to be a good tool for hedging where large exposure is involved and is expected to mature near the due date of the futures contracts. However, as compared to the flexibility available under forward contract, futures do not commend themselves hedging device in many cases. In case of small exposures, hedging may not be suitable because of the standard size of the contract. Even if large exposure is there, due to the standard size of futures contracts a position of the exposure may remain uncovered. 5. Exposure Netting If a company has both receivables and payables in a foreign currency, it need r not hedge its receivables and payables separately, but do so only for the net position. For instance, if

Option contract is preferable under the following circumstances:

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an Indian company has receivables of USD 5 million and payables r of USD 4 million, the net exposure is of USD 1 million. The technique of exposure netting involves managing the size of receivables and payables in a foreign currency, in such a way that they match or nearly match each other. This makes the company 1 remain unaffected by any change in the exchange rate of the foreign currency, concerned. The gain in receivables is offset by loss in payables, and vice versa. 6. Denomination in Local Currency The exchange risk can be totally avoided if the transaction is denominated in local currency. In such a case, the exchange risk will be borne by the other party to the transaction. For instance, if exports from India are invoiced in Indian rupees, the obligation of the importer is to pay a fixed sum of rupees. Any movement in exchange rate does not affect the exporter. The importer, on the other hand, will be bearing the exchange risk entirely. He may have to pay more in terms of the currency of his country if that currency depreciates (or rupee appreciates). lnvoicing in local currency depends upon the relative bargaining capacity of the importer and exporter and the status of the currency concerned in the international market. 7. Foreign Currency Accounts: To a trader who engages in both exports and imports or to a manufacturer exporter who imports sizeable portion of raw materials/components, the exchange risk can be minimized if an account is maintained abroad, in the currency of trade, through which all transactions can be routed. 8. Leads and Lags: Exporters and importers keep making estimates as to whether the currency will weaken (devalued) or strengthen (revalued) in future. According to these expectations, they may like to hasten or postpone the time of receipt or payment of foreign currency. This timing of payment of foreign currency depending upon the expectation of its change in value is known as 'leads and lags'. When the foreign currency is expected to be devalued, the exporter would press for payment earlier than the normal. This is because if he receives payment in foreign currency after devaluation, the amount he receives in rupee terms will be less.

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TRANSLATION EXPOSURE Translation exposure arises when an enterprise has assets or liabilities denominated in foreign currency, and these have to be shown in books of accounts in the domestic currency. Actual conversion of currencies does not take place. For the purpose of accounting, the value of the assets and liabilities denominated in foreign currency have to be translated to that of the domestic currency; and hence this exposure. It is also known as accounting exposure as it relates only to book values, and does not involve cash flows as in the case of economic exposure. Accounting exposure arises when the enterprise has subsidiaries abroad. In many countries such multinational companies are required to consolidate the assets and liabilities of the subsidiaries with those of the parent company and present consolidated financial statements. The subsidiary of the company is a separate entity with its own assets and liabilities, managing its own cash flows and operating in a foreign country. However, when the parent company prepares its final accounts, the assets and liabilities of the subsidiary company are notionally merged with its own and presented as a consolidated statement so that the readers may have an overall picture of the enterprise. For restatement of the values of the assets and liabilities and cash flows of the subsidiary in the domestic currency, the concern may apply either the historic or the current rate of exchange between the foreign currency concerned and the domestic currency. By historic rate is meant the exchange rate prevalent on the date the asset was acquired or liability was incurred. The same rate of exchange will be applied throughout the life of the asset/liability. Current rate refers to the rate of exchange prevalent on the balance-sheet date. If current rate is applied, the value of the asset/ liability keeps changing in every balance sheet. Translation exposure is defined as the likely increase or decrease in the parent company's net worth caused by a change in exchange rates since last translation. METHODS OF TRANSLATION There are principally four methods in use in deciding whether an asset/a liability should be translated or historical or current rate of exchange:

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(i) Current/Non-current Method: Under this method, the assets and liabilities of the subsidiary are classified into current and non-current categories. Current assets and liabilities are valued at current rate and non-current assets and liabilities at historical rates. (ii) Monetary/Non-monetary Method: Monetary assets and liabilities are those involving a claim to receive or an obligation to pay a fixed sum of foreign currency units. Examples of monetary assets are debtors and cash. Monetary liabilities include short and long term borrowings. Under this method monetary assets and liabilities are valued at current rates. Non-monetary items like inventory, furniture, long-term investments are translated at historical rates. (iii) Temporal Method: This is similar to monetary/non-monetary inflow with the difference in respect of inventories and investments. Under this method the inventory and investments are translated at current and investment rate if they are valued at the market price. However items of expenses based on assets carried at historical rate e.g.. Depreciation is translated at historical rates. (iv) Current Rates: Under this method all assets, liabilities, income and expenses are translated at current rates of exchange. MANAGING TRANSLATION EXPOSURE The main technique used to manage the translation exposure is known as balance sheet hedge. Some of the techniques used in managing transaction exposure are utilized here also. They include: forward cover, leading and lagging and exposure netting. 1. Balance sheet Hedge: Balance-sheet hedge consists in bringing about a balance between the exposed assets and liabilities, so that the net exposure is zero. If the exposed assets are more than the exposed liabilities, the exposure can be made zero by increasing the liability in the functional currency of the subsidiary unit without a corresponding increase in the asset. 2. Exposure Netting: The technique is similar to the one adopted under transaction exposure. 3. Leading and Lagging: A company with a positive transaction exposure has to increase the exposed liabilities or decrease the exposed assets. This can be done by expediting the

22

realization of assets. 4. Forward Contract: Forward contract is a method adopted to minimize the translation loss arising out of translation exposure. A company with a positive exposure will sell forward the exposed currency to fall due on the next balance-sheet date. The gain (or loss) arising from the exposure will be offset by the loss (or gain) on the forward contract when executed using spot market. 5. Other Methods Transfer pricing and swaps are other methods of managing translation exposure. ECONOMIC EXPOSURE Economic or operating exposure relates to the effect of unexpected exchange rates on the future operating cash flows of the company. In financial management, a firm is valued by the net present value of the future cash flows. A change in the exchange rate may bring about changes in the cash flows of the company directly by affecting its revenues and costs and indirectly by affecting its competitiveness by the action of its consumers and competitors. As a result the net present value may differ from the one anticipated. . MANAGING ECONOMIC EXPOSURE Managing economic exposure is far more difficult than managing accounting exposure. In accounting exposure, the risk involved can be easily measured and provided for economic exposure is uncertain and strategies have to be framed as situation evolves, rather than anticipating and providing for them. Economic exposure affects sales, production and the vehicle that make these possible, viz., Finance. Therefore the strategies to manage economic exposure are also around these functions. (i) (ii) (iii) Marketing Production Finance

The strategies to manage economic exposure may comprise of: a) Market Selection: A company with markets in different countries may adopt market selection as a strategy when faced with exchange rate fluctuation. It may shift its emphasis from the market whose currency has depreciated to those whose

23

currency has appreciated. b) Pricing: Pricing decision is a complex phenomenon and depends mainly on the elasticity of demand for the product and the competition faced by the company. Pricing involves considerations as: -Whether to retain the market share or retain the profit margin -How frequently can the price be changed. c) Product Decisions: Exchange rate fluctuation may have an impact on the timing of launching of a new product. The ideal time for launching the product in the foreign market will be when the home currency has depreciated. The time will also be suitable for expanding the product line and cover wider customers. d) Production Strategies: A multinational company with production and sourcing bases in different countries can manage the economic exposure by choosing the, right production and sourcing bases. The input can be procured from foreign countries, when the local currency appreciates in value. Production may be shifted from the nation whose currency has appreciated to plants in other countries. e) Financial Strategies: Financial strategies consist in minimizing the cost of borrowing by sourcing at the cheapest market and matching assets and liabilities in a currency so that the effect of exchange rate change is neutralized. These manipulations can be done relatively easily by a multinational company which has access to different markets. A domestic based company may find it difficult to adopt them. CONCLUSION Transaction exposure is readily recognized and provided for by companies in India. The classical method used is the forward contract. Translation exposure is applicable to Indian companies only in a limited way. Economic exposure has wider; ramifications, but least recognized. With the greater awareness, companies are now devoting more time in managing economic exposure also. In the world of competition and liberalisation, the survival and growth of business enterprises depends significantly on how well they recognize and manage effectively the exchange risk and exposure.

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RESEARCH DESIGN
STATEMENT OF PROBLEM In the world of globalization and international business, where a company would be performing one or the other kind of activity like selling its products, sourcing its raw materials, raising funds abroad, investing in the international markets it has to deal with many currencies for making payments or receiving its receipts. So the firms would be facing the currency risk where an appreciation or depreciation of the currency it is dealing with may eat away its profits, so there arises the opportunity of managing the currency risk. This project thus deals with the various strategies by which those risk could be managed. TITLE OF THE STUDY: RISK MANAGEMENT IN FOREIGN EXCHANGE OVERVIEW: The project goes the following way: Identify the various forms of exposures (Transaction, Translation and Economic exposures) a company is facing The ways of measuring them The various ways by which they can be managed and its effects. A paired sample t-test was to find out which tool best suits the firm. SCOPE OF THE STUDY: The scope of the study is to see the various strategies to manage the various forms of exposures and includes a detailed study of currency forwards, currency options, swaps, exposure netting, risk sharing and shifting. And also areas like interest rate parity, purchasing power parity and pricing of currency options.

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OBJECTIVES OF THE STUDY: To understand the concepts of FOREIGN EXCHAGE To know the various methods of managing transaction exposures and the benefits from them. To under stand the various forms of managing translation exposures And also economic exposures. The study on forex market. TYPE OF THE STUDY: The objective of the study was determined first and the various forms of dealing it so the study dealt in this study is a DESCRIPTIVE STUDY. SAMPLING: For the purpose of the study, non-probabilistic convenient sampling technique has been used. DATA COLLECTION: The currency rates of the countries were collected on the various web sites and then they were analyzed. LIMITATIONS OF THE STUDY: The project only takes up the dealing in one currency however the strategies are same for all the currencies but a fundamental study about the currency helps for the better implementation of the techniques which the project has not dealt in detail. The study deals with the historical data for its accuracy of testing. As the methodology uses the statistical tools hence, all the constraints of statistics are applicable.

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ORIGINS OF FOREX MARKET In order to gain a complete understanding of what foreign exchange is, it is useful to examine the reasons that lead to its existence in the first place. Exhaustively detailing the historical events that shaped the foreign exchange market into what it is today is of no great importance to the fx trader and therefore we happily will omit lengthy explanations of historical events such as the Bretton Woods accord in favor of a more specific insight into the reasoning behind foreign exchange as a medium of exchange of goods and services. Originally our ancestors conducted trading of goods against other goods this system of bartering was of course quite inefficient and required lengthy negotiation and searching to be able to strike a deal. Eventually forms of metal like bronze, silver and gold came to be used in standardized sizes and later grades (purity) to facilitate the exchange of merchandise. The basis for these mediums of exchange was acceptance by the general public and practical variables like durability and storage. Eventually during the late middle ages, a variety of paper IOU started gaining popularity as an exchange medium. The obvious advantage of carrying around 'precious' paper versus carrying around bags of precious metal was slowly recognized through the ages. Eventually stable governments adopted paper currency and backed the value of the paper with gold reserves. This came to be known as the gold standard. The Bretton Woods accord in July 1944 fixed the dollar to 35 USD per ounce and other currencies to the dollar. In 1971, president Nixon suspended the convertibility to gold and let the US dollar 'float' against other currencies. Since then the foreign exchange market has developed into the largest market in the world with a total daily turnover of about 1.5 trillion USD. Traditionally an institutional (inter-bank) market, the popularity of online currency trading offered to the private individual is democratizing foreign exchange and widening the retail market.

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ADVANTAGES OF FOREX Although the forex market is by far the largest and most liquid in the world, day traders have up to now focused on seeking profits in mainly stock and futures markets. This is mainly due to the restrictive nature of bank-offered forex trading services. Advanced Currency Markets (ACM) offers both online and traditional phone forextrading services to the small investor with minimum account opening values starting at 5000 USD. There are many advantages to trading spot foreign exchange as opposed to trading stocks and futures. Below are listed those main advantages. 1. Bid/Ask Spread rates Spread rates have tightened dramatically in the last years. Most online forex brokers offer a spread of 5 pips on EURUSD which is the most widely traded and liquid currency pair. ACM offers a 3-pip spread on EURUSD. In stock trading, only liquid stocks offer tight spreads. Those spreads often represent on average between 0.04% and 0.06% of the value of the stock. In comparison ACM offers a 3 pip spread on all major currencies, this equates to approximately between 0.02% and 0.03% on the underlying dollar value. Exact percentages at current rates (May 2002) EURUSD GBPUSD USDJPY USDCHF 3 pips 3 pips 3 pips 3 pips 0.03% 0.03% 0.023% 0.018%

In the futures market spreads can vary anywhere between 5 and 9 pips and can become even larger under illiquid market conditions (which tends to happen substantially more often in futures currencies). 2. Commissions ACM offers foreign exchange trading commission free. This is in sharp contrast to (once again) what stock and futures brokers offer. A stock trade can cost anywhere between USD 5 and 30 per trade with online brokers and typically up to USD 150 with full service brokers. Futures brokers can charge commissions anywhere between USD 10 and 30 on a round turn basis.

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3. Margins requirements ACM offers a foreign exchange trading with a 1% margin. In layman's terms that means a trader can control a position of a value of USD 1'000'000 with a mere USD 10'000 in his account. By comparison, futures margins are not only constantly changing but are also often quite sizeable. Stocks are generally traded on a non-margined basis and when they are, it can be as restrictive as 50% or so. 4. 24 hour market Foreign exchange market trading occurs over a 24 hour period picking up in Asia around 24:00 CET Sunday evening and coming to an end in the United States on Friday around 23:00 CET. Although ECNs (electronic communications networks) exist for stock markets and futures markets (like Globex) that supply after hours trading, liquidity is often low and prices offered can often be uncompetitive. 5. No Limit up / limit down Futures markets contain certain constraints that limit the number and type of transactions a trader can make under certain price conditions. When the price of a certain currency rises or falls beyond a certain pre-determined daily level traders are restricted from initiating new positions and are limited only to liquidating existing positions if they so desire. This mechanism is meant to control daily price volatility but in effect since the futures currency market follows the spot market anyway, the following day the futures market may undergo what is called a 'gap' or in other words the futures price will readjust to the spot price the next day. In the OTC market no such trading constraints exist permitting the trader to truly implement his trading strategy to the fullest extent. Since a trader can protect his position from large unexpected price movements with stop-loss orders the high volatility in the spot market can be fully controlled. 6. Sell before you buy Equity brokers offer very restrictive short-selling margin requirements to customers. This means that a customer does not possess the liquidity to be able to sell stock before he

29

buys it. Margin wise, a trader has exactly the same capacity when initiating a selling or buying position in the spot market. In spot trading when you're selling one currency, you're necessarily buying another. MARKET PARTICIPANTS In the last years, the foreign exchange market has expanded from one where banks would execute transactions between themselves to one in which many other kinds of financial institutions like brokers and market-makers participate including non-financial corporations, investment firms, pension funds and hedge funds. Its' focus has broadened from servicing importers and exporters to handling the vast amounts of overseas investment and other capital flows that currently take place. Lately foreign exchange day trading has become increasingly popular and various firms offer trading facilities to the small investor. Foreign exchange is an 'over the counter' (OTC) market, that means that there is no central exchange and clearing house where orders are matched. Geographic trading 'centers' exist around the world however and are: (in order of importance) London, New York, Tokyo, Singapore, Frankfurt, Geneva & Zurich, Paris and Hong Kong. Essentially foreign exchange deals are made between participants on the basis of trust and reputation to deliver on an agreement. In the case of banks trading with one another, they do so solely on that basis. In the retail market, customers demand a written legally accepted contract between themselves and their broker in exchange of a deposit of funds on which basis the customer may trade. Some market participants may be involved in the 'goods' market, conducting international transactions for the purchase or sale of merchandise. Some may be engaged in 'direct investment' in plant and equipment, or may be in the 'money market,' trading short-term debt instruments internationally. The various investors, hedgers, and speculators may be focused on any time period, from a few minutes to several years. But, whether official or

30

private, and whether their motive be investing, hedging, speculating, arbitraging, paying for imports, or seeking to influence the rate, they are all part of the aggregate demand for and supply of the currencies involved, and they all play a role in determining the exchange rate at that moment. MAIN FOREX MARKETS Foreign exchange is traded essentially in two distinctive ways. Over an organized exchange and 'over the counter'. Exchange traded foreign exchange represents a very small portion of the total foreign exchange market the great majority of foreign exchange deals being traded between banks and other market participants 'over the counter'. 1. Exchange traded currencies In the case of an organized exchange like the Chicago Mercantile exchange (CME) in the US, standardized currency contract sizes that represent a certain monetary value are traded in the International money market (IMM). A central clearing house organizes matching of transactions between counter-parties. 2. Forex market In comparison the over the counter market is traded around the world by a multitude of participants and price quality, reputation and trading conditions determine who a participant wishes to trade with. It is probably the most competitive market in the world and brokers like ACM must insure they live up to the highest standards of service and be compliant with market standards and practices if they want to acquire new customers and retain their existing ones. In 1998 a survey under the auspices of the Bank for International Settlements (BIS), global turnover of reporting dealers was estimated at about USD 1.49 trillion per day. In comparison, currency futures turnover was estimated at USD 12 billion. 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 British pound is less widely traded in the market than several others. As shown in the graph underneath, the United Kingdom accounts for about 32 percent of the global total; the United States ranks a distant second with about 18 percent, and Japan is third with 8 percent

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MARKET DYNAMICS The breadth, depth, and liquidity of the market are truly impressive. It has been estimated that the world's most active exchange rates like EURUSD and USDJPY can change up to 18,000 times during a single day. 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. 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 starts. Finally, completing the circle, when it is middle or late afternoon 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 graph underneath displays not only the trading time cycle but also the average 'depth' of trading at different times during the day in the various business hours.

1. Spot rate

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A spot transaction is a straightforward (or outright) exchange of one currency for another. The spot rate is the current market price or 'cash' rate. Spot transactions do not require immediate settlement, or payment 'on the spot'. By convention, the settlement date, or value date, is the second business day after the deal date on which the two parties make the transaction. 2. Bid & ask In the foreign exchange market (and essentially in all markets) there is a buying and selling price. It is important to perceive these prices as a reflection of market condition. A market maker is expected to quote simultaneously for his customers both a price at which he is willing to buy (the bid) and a price at which he is willing to sell (the ask) standard amounts of any currency for which he is making a market. ACM quotes very competitive spreads to customers, to site an example if a trader is interested in a transaction in EURUSD then he can trade on a bid/ask of say 0.9150 / 0.9153. This means that ACM is willing to buy from him a pre-determined amount at 0.9150 or inversely to sell to him at 0.9153. Generally speaking the difference between the bid and ask rates reflect the level of liquidity in a certain instrument. On a normal trading day, the major currency pairs EURUSD, USDJPY, USDCHF and GBPUSD are traded by a multitude of market participant every few seconds. High liquidity means that there is always a seller for your buy and a buyer for your sell at actual prices. 3. Base currency and counter currency Every foreign exchange transaction involves two currencies. It is important to keep straight which is the base currency and which is the counter currency. The counter currency is the numerator and the base currency is the denominator. When the counter currency increases, the base currency strengthens and becomes more expensive. When the counter currency decreases, the base currency weakens and becomes cheaper. In telephone trading communications, the base currency is always stated first. For example, a quotation for USDJPY means the US dollar is the base and the yen is the counter currency. In the case of GBPUSD (usually called 'cable') the British pound is the base and the US dollar is the counter currency. 4. Quotes in terms of base currency

33

Traders always think in terms of how much it costs to buy or sell the base currency. When a quote of 0.9150 / 53 is given that means that a trader can buy EUR against USD at 0.9153. If he is buying EURUSD for 1'000'000 at that rate he would have USD 915'300 in exchange for his million Euros. Of course traders are not actually interested in exchanging large amounts of different currency, their main focus is to buy at a low rate and sell at higher one. 5. Basis points or 'pips' For most currencies, bid and offer quotes are carried down to the fourth decimal place. That represents one-hundredth of one percent, or 1/10,000th of the counter currency unit, usually called a 'pip'. However, for a few currency units that are relatively small in absolute value, such as the Japanese yen, quotes may be carried down to two decimal places and a 'pip' is 1/100th of the terms currency unit. In foreign exchange, a 'pip' is the smallest amount by which a price may fluctuate in that market. 6. Euro cross & cross rates Euro cross rates are currency pairs that involve the Euro currency versus another currency. Examples of Euro crosses are EURJPY, EURCHF and GBPEUR. Currency pairs that involve neither the Euro nor the US dollar are called cross rates. Examples of cross rates are GBPJPY and CHFJPY. Of course hundreds of cross rates exist involving exotic currency pairs but they are often plagued by low liquidity. Ever since the Euro the number of liquid cross rates have decreased and have been replaced (to a certain extent) by Euro crosses Trading Opportunities The sheer number of currencies traded serves to ensure a rather extreme level of volatility on a day-to-day basis. There will always be currencies that are moving rapidly up or down, offering opportunities for profit (and commensurate risk) to astute traders. Yet, like the equity markets, forex offers plenty of instruments to mitigate risk and allows the individual to profit in both rising and falling markets. Forex also allows highly leveraged trading with low margin requirements relative to its equity counterparts. Perhaps best of all, forex charges zero dealing commissions! Many of the instruments utilized in forex - such as forwards and futures, options, spread

34

betting, contracts for difference and the spot market - will appear similar to those used in the equity markets. Since the instruments on the forex often maintain minimum trade sizes in terms of the base currencies (the spot market, for example, requires a minimum trade size of 100,000 units of the base currency), the use of margin is absolutely essential for the person trading these instruments. Buying and Selling Currencies Regarding the specifics of buying and selling on forex, it is important to note that currencies are always priced in pairs. All trades result in the simultaneous purchase of one currency and the sale of another. While trading on the forex, you would execute a trade only at a time when you expect the currency you are buying to increase in value relative to the one you are selling. If the currency you are buying does increase in value, you must sell the other currency back in order to lock in a profit. An open trade (or open position), therefore, is a trade in which a trader has bought or sold a particular currency pair and has not yet sold or bought back the equivalent amount to close the position. More about Margin Trading in the currency markets requires a trader to think in a slightly different way also about margin. Margin on the forex is not a down payment on a future purchase of equity but a deposit to the trader's account that will cover against any currency-trading losses in the future. A typical currency trading system will allow for a very high degree of leverage in its margin requirements, up to 100:1. The system will automatically calculate the funds necessary for current positions and will check for margin availability before executing any trade. Rollover In the spot forex market, trades must be settled within two business days. For example, if a trader sells a certain number of currency units on Wednesday, he or she must deliver an equivalent number of units on Friday. But currency trading systems may allow for a "rollover", with which open positions can be swapped forward to the next settlement date (giving an extension of two additional business days). The interest rate for such a swap is predetermined, and, in fact, these swaps are actually financial instruments that can also be traded on the currency market.

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In any spot rollover transaction the difference between the interest rates of the base and counter currencies is reflected as an overnight loan. If the trader holds a long position in the currency with the higher interest rate, he or she would gain on the spot rollover. The amount of such a gain would fluctuate day-to-day according to the precise interest-rate differential between the base and the counter currency. Such rollover rates are quoted in dollars and are shown in the interest column of the forex trading system. Rollovers, however, will not affect traders who never hold a position overnight since the rollover is exclusively a day-to-day phenomenon. CONCLUSION As one can immediately see, trading in forex requires a slightly different way of thinking than the way required by equity markets. Yet, for its extreme liquidity, multitudes of opportunities for large profits due to strong trends and high levels of available leverage, the currency market are hard to resist for the advanced trader. With such potential, however, comes significant risk, and traders should quickly establish an intimate familiarity with methods of risk management.

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In order to known the effects of the various risk management strategies a various series of inflows and outflows were assumed. The series of inflows or outflows were assumed in US Dollars and the same strategies could be used for any other currencies. In order to see its effects in the actual market the historical data was taken for the calculation. Series 1: Assuming the firm/company has entered into a contract on 1 st Jan 2005 and it is receiving/paying 35000US Dollars. So in order to hedge this position the firm can go with many risk management strategies. A) Receiving Dollars and its effects. Without hedging: Table no 1:- Receiving dollars and not hedging the position. DATE 3-Jan-05 4-Apr-05 $ RATE 43.6100 43.7600 $ INFLOWS 35000.0000 35000.0000 RS. INFLOWS 1526350.0000 1531600.0000

Supposed to receive Actual receipt Profit/Loss Hedge with forward contract:

1526350.0000 1531600.0000 5250.0000

To hedge with forward contract the forward premium or discount should be known, in order for a greater exposure towards the project these rates were not taken from the internet but calculated manually using Purchasing Power Parity (PPP) and Interest Rate Parity (IRP). US LIBOR as on 1st Jan 2005 was 2.5892% Indian MIBOR as on 1st Jan 2005 was 5.45%

37

So according to IRP Indian rupee against USD will depreciate by 2.8606% (5.45%2.5892%) over a year. US inflation as on 1st Jan 2005 was 2.97% Indian inflation as on 1st Jan was 4.72% So according to PPP Indian rupee will depreciate by 1.75% against USD over one year. For the above calculation of premium or discount PPP and IRP were taken having equal weights. Table no 2:- Receiving dollars and hedging the position with a forward contract. FORWARD FORWARD FORWARD RATE (IRP) RATE (PPP) RATE $ INFLOWS RS INFLOWS 43.6100 43.9219 43.6100 43.8008 43.6100 43.8613 35000.0000 35000.0000 1526350.0000 1535147.1182

DATE 03-Jan-05 04-Apr-05

Supposed to receive Actual receipt Profit/Loss Hedge using an Option:

1526350.0000 1541615.0000 15265.0000

To enter into an option, the option premium should be known. So the premium was calculated using the Black and Sholes model. Since we are receiving Dollar we enter into a put option. Standard deviation of the currency (1/1/04 31/12/04) 0.7640 Strike price (S) assumed to be 43.00 Under lying price (X) as on 1/1/2005 43.61 Mibor rate (r) as on 1/1/2005 Time to expiration ( t = 90days/365days ) 0.2466 LN refers to Natural Logarithm N refers to normal distribution

38

E refers to exponential distribution The option premium is calculated with the formula

D1 = LN(X/S) + 0.5(S^2)(t) / S* t D2 = D1- S* t Premium = X * e- rt * N (-d2) - S * N (-d1) Option premium = 0.7484 Table no 3:- Receiving dollars and hedging the position with an option contract. COST IF COST IF $ OPTION OPTION IS STRIKE DATE RATE EXPIRES PREMIUM ACTIVE PRICE $INFLOWS RECIEPTS 04-Apr05 43.7600 43.0116 0.7484 43.2516 44.0000 35000.0000 1513806

Supposed to receive Actual receipt Profit/Loss Risk shifting:

1526350.0000 1513806.0000 -12544.0000

Refers to invoicing the contract in Indian rupee leaving the counter party to take up risk. This could be taken as the risk free return. Table no 4:- Receiving dollars and hedging the position by shifting the risk DATE 03-Jan-05 04-Apr-05 DOLLAR RATE 43.6100 43.7600 CF 1526350.0000 1526350.0000

Supposed to receive Actual receipt Profit/Loss

1526350.0000 1526350.0000 0.0000

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Exposure netting: This refers to hedging the contract with negatively or positively correlated currencies. For this purpose 20 currencies of different countries was taken and their correlation with the USD was found to get the results as Australian dollar being most vely and Saudi Arabian riyal being the most +vely correlated currencies against USD. 1) Assuming we are receiving dollar so with Australian dollar we go long Table no 5:- Receiving dollars and hedging the position by exposure netting DOLLAR AUS $ RETURN RETURN DATE RATE RATES ON $ ON AUS $ 3-Jan-05 43.61000 34.04835 4-Apr-05 43.76000 33.50084 0.15000 -0.54751 -0.39751 NET RETURN EFFECTIVE NET $ RATE INFLOWS 43.61000 43.36249 1526350.00 1517687.11

Supposed to receive Actual receipt Profit/Loss

1526350.0000 1517687.1103 -8662.8897

2) Assuming we r receiving dollar we are going short on Saudi Arabian riyal Table no 6:- Receiving dollars and hedging the position by exposure netting DOLLAR SA RETURN RETURN RATE RIYAL ON $ ON SA R NET RETURN EFFECTIVE NET $ RATE INFLOWS 43.61000 -0.04594 0.19594 43.95594 1526350.00 1538457.86

DATE

3-Jan-05 43.61000 11.64687 4-Apr-05 43.76000 11.60093 0.15000

Supposed to receive

1526350.0000

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Actual receipt Profit/Loss Swaps:

1538457.8621 12107.8621

Assuming another us firm is at the same position but receiving the money in Indian rupee they can enter into plain vanilla swap locking the exchange rates Table no 7:- Receiving dollars and hedging the position by swap contract DATE 03-Jan-05 04-Apr-05 CINF OF CINF OF US EXCHANGE INDIAN FIRM FIRM RATES 35000.0000 35000.0000 1526350.0000 1526350.0000 43.6100 43.6100 MARKET EX- RATE 43.6100 43.7600 CF AFTER CONVERSION 1526350.0000 1526350.0000

Supposed to receive Actual receipt Profit/Loss Risk sharing:

1526350.0000 1526350.0000 0.0000

Under this strategy the two firms fixes a band if on the date of execution if the ex-rate falls with in the band, the execution takes place at the market rate and if it falls outside the band the risk is shared equally. Lets assume a band 43.6 to 43.7, if the exchange rate is between the band it is directly converted or the risk is equally shared. Table no 8:- Receiving dollars and hedging the position with the help of risk sharing DATE 03-Jan-05 04-Apr-05 DOLLAR RATE 43.6100 43.7600 $ INFLOWS 35000.0000 35000.0000 NET INFLOWS 1526350.0000 1530550.0000

Supposed to receive

1526350.0000

41

Actual receipt Profit/Loss B) Paying dollar and its effects Without hedge

1530550.0000 4200.0000

Table no 9:- Paying dollars and not hedging the position. DATE 3-Jan-05 4-Apr-05 $ RATE 43.6100 43.7600 $ INFLOWS 35000.0000 35000.0000 RS. INFLOWS 1526350.0000 1531600.0000

Supposed to pay Actual payment Profit/Loss Hedge with a forward contract:

1526350.0000 1531600.0000 -5250.0000

Table no 10:- Paying dollars and hedging the position with a forward contract. DATE 03-Jan-05 04-Apr-05 FORWARD FORWARD RATE (IRP) RATE (PPP) 43.6100 43.9219 43.6100 43.8008 FORWARD RATE $ INFLOWS RS INFLOWS 43.6100 43.8613 35000.0000 35000.0000 1526350.0000 1535147.1182

Supposed to pay Actual payment Profit/Loss Hedge with an option contract:

1526350.0000 1541615.0000 -15265.0000

42

To enter into an option, the option premium should be known. So the premium was calculated using the Black and Sholes model. Since we are receiving Dollar we enter into a call option. All variables and its value being same the premium is calculated with the following formula: D1 = LN(X/S) + 0.5(S^2)(t) / S* t D2 = D1- S* t Premium = (ND1 * X) - (ND2 * S) * e- rt Option premium = 1.5891 Table no 11:- Paying dollars and hedging the position with an option contract. COST IF COST IF $ OPTION OPTION IS STRIKE COST ON DATE RATES EXPIRES PREMIUM ACTIVE PRICE $INFLOWS EXPIRATION 4-Apr05 43.7600

45.3491

1.5891

43.5891

42.0000 35000.0000 1525618.5000

Supposed to pay Actual payment Profit/Loss Risk shifting:

1526350.0000 1525618.5000 731.5000

Table no 12:- Paying dollars and hedging the position by shifting the risk. DATE 03-Jan-05 04-Apr-05 DOLLAR RATE 43.6100 43.7600 CF 1526350.0000 1526350.0000

Supposed to pay

1526350.0000

43

Actual payment Profit/Loss

1526350.0000 0.0000

Exposure netting 1) Assuming we are paying dollar so with Australian dollar we go short Table no 13:- Paying dollars and hedging the position by exposure netting. DOLLAR AUS $ RETURN RETURN NET EFFECTIVE NET RATE RATES ON $ ON AUS $ RETURN $ RATE INFLOWS 34.0483 33.5008 0.1500 -0.5475 -0.3975 43.6100 43.3625 1526350.0000 1517687.1103

DATE

03-Jan-05 43.6100 04-Apr05 43.7600

Supposed to pay Actual payment Profit/Loss

1526350.0000 1517687.1103 8662.8897

2) Assuming we r paying dollar we are going long on Saudi Arabian riyal Table no 14:- Paying dollars and hedging the position by exposure netting. DOLLAR SA RETURN RETURN NET EFFECTIVE NET DATE RATE RIYAL ON $ ON SA R RETURN $ RATE INFLOWS 03-Jan-05 43.6100 11.6469 04-Apr-05 43.7600 11.6009 0.1500 -0.0459 0.1959 43.6100 43.9559 1526350.0000 1538457.8621

44

Supposed to pay Actual payment Profit/Loss Swaps:

1526350.0000 1538457.8621 -12107.8621

Table no 15:- Paying dollars and hedging the position by a swap contract. CF OF CF OF US INDIAN FIRM FIRM EXCHANGE MARKET CF AFTER RATES EX RATE CONVERSION

DATE

03-Jan-05 04-Apr05

35000.0000

1526350.0000

43.6100

43.6100

1526350.0000

35000.0000

1526350.0000

43.6100

43.7600

1526350.0000

Supposed to pay Actual payment Profit/Loss Risk sharing:

1526350.0000 1526350.0000 0.0000

Table no 16:- Paying dollars and hedging the position with the contract of risk sharing. DOLLAR RATE 43.6100 43.7600

DATE 03-Jan-05 04-Apr-05

$ INFLOWS 35000.0000 35000.0000

NET INFLOWS 1526350.0000 1530550.0000

45

Supposed to pay Actual payment Profit/Loss INTERPRETATION:

1526350.0000 1530550.0000 -4200.0000

From the above calculation it is clear that with out hedging the contract the firms profits could range from +5250 to 5250, which could eat away the firms profits if its falls on the other side. By hedging the situation the firm, if not the entire amount could save some extent of its profits. With the forward contract hedge the company can actually be on the neutral side if the currency neither at premium nor at discount but that rarely happens, but still the firm could save some extent, if the inflation is high there is the chance that the currency would depreciate leading to a high cost of production and a increased return on the inflows of the currency depreciation. With the option the firm could make some profits on the call option. Deciding the strike price would be a major factor the firm and can take advantage over the abnormally priced options. But the option has a great advantage to exercise on any day before the strike day, which could not be reflected in the above calculation. By shifting the risk the firm could gain on the currency risk but it is actually losing because of the time value of the money and if there is inflation the company would be increasing its cost of production. This also to a great extent depends on the bargaining power of the firm. By exposure netting the firm could gain to a greater extent if the currencies follow the same correlation as before but in the real world it does not happen to a greater extent because of many factors influencing the exchange rate. Swaps was also found to be the best option as a risk management strategy but the finding of the right swap partner to suit all things such as the date with the same inflows would be very difficult in the real world.

46

By sharing the risk the firm could reduce its risk of ve 5250 to a -ve 4200 Rs, the firm could reduce its risk to a still less extent by setting its band properly.

Series 2: Assuming the firm/company has entered into a contract on 1st Jan 2004 and it is receiving/paying 10000US Dollars every month for a period of 17 months. So in order to hedge this position the firm can go with many risk management strategies. The results were measured using a tool beta return or cost. Where in, beta of final cash inflows or out flows after conversion were measured against the market currency exchange rate. The beta return is measured by, the excess return the firm gets over its risk level (beta). A) Receiving dollars and its effects With out hedge Table no 17:- Receiving dollars and not hedging the position DATE 01/01/2004 03/02/2004 01/03/2004 02/04/2004 03/05/2004 01/06/2004 01/07/2004 02/08/2004 01/09/2004 01/10/2004 01/11/2004 01/12/2004 03/01/2005 DOLLAR RATE 45.6100 45.3000 45.2400 43.7700 44.9700 45.4500 45.8800 46.3600 46.3300 45.9200 45.4100 44.4700 43.6100 CF 10000.0000 10000.0000 10000.0000 10000.0000 10000.0000 10000.0000 10000.0000 10000.0000 10000.0000 10000.0000 10000.0000 10000.0000 10000.0000 CF IN RS 456100.0000 453000.0000 452400.0000 437700.0000 449700.0000 454500.0000 458800.0000 463600.0000 463300.0000 459200.0000 454100.0000 444700.0000 436100.0000

47

01/02/2005 01/03/2005 04/04/2005 02/05/2005

43.6800 43.7200 43.7600 43.5700

10000.0000 10000.0000 10000.0000 10000.0000

436800.0000 437200.0000 437600.0000 435700.0000

BETA SUM BETA RETURN Hedge with a forward contact:

9411.7647 7630500.0000 -13.0900

US LIBOR as on 1st Jan 2004 was 1.0982% Indian MIBOR as on 1st Jan 2004 was 4.70% So according to IRP Indian rupee against USD will depreciate by 3.6018% (4.70%1.0982%) over a year. US inflation as on 1st Jan 2004 was 2.68% Indian inflation as on 1st Jan 2004 was 5.50% So according to PPP Indian rupee will depreciate by 2.82% against USD over one year.

48

Table no 18:- Receiving dollars and hedging the position with a forward contract. FORWARD RATE FORWARD FORWARD $ RS $ DATE (IRP) RATE (PPP) RATE INFLOWS INFLOWS RATES 01/01/2004 03/02/2004 01/03/2004 02/04/2004 03/05/2004 01/06/2004 01/07/2004 02/08/2004 01/09/2004 01/10/2004 01/11/2004 01/12/2004 03/01/2005 01/02/2005 01/03/2005 04/04/2005 02/05/2005 45.6100 45.7469 45.8838 46.0207 46.1576 46.2945 46.4314 46.5683 46.7052 46.8421 46.9790 47.1159 47.2528 47.3897 47.5266 47.6635 47.8004 45.6100 45.7172 45.8244 45.9316 46.0387 46.1459 46.2531 46.3603 46.4675 46.5747 46.6818 46.7890 46.8962 47.0034 47.1106 47.2178 47.3249 45.6100 45.7320 45.8541 45.9761 46.0982 46.2202 46.3422 46.4643 46.5863 46.7084 46.8304 46.9525 47.0745 47.1965 47.3186 47.4406 47.5627 10000.0000 456100.0000 45.6100 10000.0000 457320.4096 45.3000 10000.0000 458540.8192 45.2400 10000.0000 459761.2287 43.7700 10000.0000 460981.6383 44.9700 10000.0000 462202.0479 45.4500 10000.0000 463422.4575 45.8800 10000.0000 464642.8670 46.3600 10000.0000 465863.2766 46.3300 10000.0000 467083.6862 45.9200 10000.0000 468304.0958 45.4100 10000.0000 469524.5053 44.4700 10000.0000 470744.9149 43.6100 10000.0000 471965.3245 43.6800 10000.0000 473185.7341 43.7200 10000.0000 474406.1436 43.7600 10000.0000 475626.5532 43.5700

BETA

-3213.4482 49

RETURN BETA RETURN Hedge with an option:

7919675.7022 -51.6503

Standard deviation of the currency (1/1/03 31/12/03) 0.9163 Mibor rate (r) as on 1/1/2004 4.70% Time accepting the theorem that longer the duration higher the premium for all the inflows the contract is entered just before a month (30/365) 0.0822 Table no 19:- Receiving dollars and hedging the position with an option contract. COST IF COST IF $ OPTION OPTION STRIKE COST ON DATE RATES EXPIRES PREMIUM ACT PRICE $INFLOWS EXPIRATION 01/01/2004 45.6100 03/02/2004 45.3000 01/03/2004 45.2400 02/04/2004 43.7700 03/05/2004 44.9700 01/06/2004 45.4500 01/07/2004 45.8800 02/08/2004 46.3600 01/09/2004 46.3300 01/10/2004 45.9200 01/11/2004 45.4100 01/12/2004 44.4700 03/01/2005 43.6100 01/02/2005 43.6800 01/03/2005 43.7200 04/04/2005 43.7600 42.0620 41.7797 40.2063 40.5607 41.5995 42.1971 42.8159 42.9455 42.4485 41.6629 40.3859 38.9393 38.4323 38.4283 38.4064 3.2380 3.4603 3.5637 4.4093 3.8505 3.6829 3.5441 3.3845 3.4715 3.7471 4.0841 4.6707 5.2477 5.2917 5.3536 43.3864 43.2886 43.3095 42.5884 43.2716 43.5637 43.8269 44.1108 44.1483 43.9971 43.7846 43.3223 42.8698 42.9502 43.0127 10000.0000 456100.0000 46.6244 10000.0000 433863.7933 46.7488 10000.0000 432885.8953 46.8733 10000.0000 433095.3817 46.9977 10000.0000 425883.5094 47.1221 10000.0000 432716.4180 47.2465 10000.0000 435636.5435 47.3710 10000.0000 438268.5324 47.4954 10000.0000 441108.4838 47.6198 10000.0000 441483.2375 47.7442 10000.0000 439970.9193 47.8686 10000.0000 437845.6494 47.9931 10000.0000 433223.2766 48.1175 10000.0000 428698.0926 48.2419 10000.0000 429502.1235 48.3663 10000.0000 430127.4165

50

02/05/2005 43.5700

38.1543

5.4157

43.0751

48.4908 10000.0000 430750.9364

BETA RETURN BETA RETURN Risk shifting:

3623.0164 7401160.2091 -97.3056

Table no 20:- Receiving dollars and hedging the position by shifting the risk DATE 01/01/2004 03/02/2004 01/03/2004 02/04/2004 03/05/2004 01/06/2004 01/07/2004 02/08/2004 01/09/2004 01/10/2004 01/11/2004 01/12/2004 03/01/2005 01/02/2005 01/03/2005 04/04/2005 02/05/2005 DOLLAR RATE 45.6100 45.3000 45.2400 43.7700 44.9700 45.4500 45.8800 46.3600 46.3300 45.9200 45.4100 44.4700 43.6100 43.6800 43.7200 43.7600 43.5700 CF 456100.0000 456100.0000 456100.0000 456100.0000 456100.0000 456100.0000 456100.0000 456100.0000 456100.0000 456100.0000 456100.0000 456100.0000 456100.0000 456100.0000 456100.0000 456100.0000 456100.0000

BETA RETURN

0.0000 7753700.0000

51

BETA RETURN Exposure netting

0.0000

This refers to hedging the contract with negatively or positively correlated currencies. For this purpose 20 currencies of different countries was taken and their correlation with the USD was found to get the results as Australian dollar being most vely and Saudi Arabian riyal being the most +vely correlated currencies against USD. 1) Assuming we are receiving dollar so with Australian dollar we go long Table no 21:- Receiving dollars and hedging the position by exposure netting RETURN DOLLAR AUS $ RETURN ON AUS NET EFFECTIVE NET DATE RATE RATES ON $ $ RETURN $ RATE INFLOWS 01/01/2004 45.6100 03/02/2004 45.3000 01/03/2004 45.2400 02/04/2004 43.7700 03/05/2004 44.9700 01/06/2004 45.4500 01/07/2004 45.8800 02/08/2004 46.3600 01/09/2004 46.3300 01/10/2004 45.9200 01/11/2004 45.4100 01/12/2004 44.4700 03/01/2005 43.6100 01/02/2005 43.6800 01/03/2005 43.7200 04/04/2005 43.7600 02/05/2005 43.5700 34.2349 34.2466 34.9162 33.2557 31.9591 32.3834 32.0718 32.5521 32.5627 33.3444 33.9098 34.3171 33.8295 33.7724 34.5423 33.5008 33.8868 -0.3100 -0.3700 -1.8400 -0.6400 -0.1600 0.2700 0.7500 0.7200 0.3100 -0.2000 -1.1400 -2.0000 -1.9300 -1.8900 -1.8500 -2.0400 0.0117 0.6814 -0.9791 -2.2758 -1.8514 -2.1630 -1.6828 -1.6722 -0.8904 -0.3251 0.0822 -0.4054 -0.4625 0.3075 -0.7340 -0.3480 -0.2983 0.3114 -2.8191 -2.9158 -2.0114 -1.8930 -0.9328 -0.9522 -0.5804 -0.5251 -1.0578 -2.4054 -2.3925 -1.5825 -2.5840 -2.3880 45.6100 45.0017 45.5514 40.9509 42.0542 43.4386 43.9870 45.4272 45.3778 45.3396 44.8849 43.4122 41.2046 41.2875 42.1375 41.1760 41.1820 456100.0000 450017.2426 455513.5004 409508.8554 420542.4128 434385.6861 439869.8985 454272.3225 453778.3209 453395.9707 448849.4885 434122.3883 412046.4825 412875.2312 421374.6326 411759.8644 411819.6695

52

BETA RETURN BETA RETURN

15378.4124 7380231.9669 -24.2852

2) Assuming we r receiving dollar we are going short on Saudi Arabian riyal Table no 22:- Receiving dollars and hedging the position by exposure netting DOLLAR SA RETURN RETURN NET EFFECTIVE NET DATE RATE RIYAL ON $ ON SA R RETURN $ RATE INFLOWS 01/01/2004 45.6100 12.1433 03/02/2004 45.3000 12.0453 -0.3100 01/03/2004 45.2400 12.0467 -0.3700 02/04/2004 43.7700 11.5380 -1.8400 03/05/2004 44.9700 11.8106 -0.6400 01/06/2004 45.4500 12.0773 -0.1600 01/07/2004 45.8800 12.2324 02/08/2004 46.3600 12.3335 01/09/2004 46.3300 12.3274 01/10/2004 45.9200 12.2130 0.2700 0.7500 0.7200 0.3100 0.0980 0.0965 0.6053 0.3327 0.0660 -0.0891 -0.1902 -0.1841 -0.0697 0.0602 0.2823 0.5933 0.5194 0.5181 0.5424 0.5612 0.4080 0.4665 2.4453 0.9727 0.2260 -0.3591 -0.9402 -0.9041 -0.3797 0.2602 1.4223 2.5933 2.4494 2.4081 2.3924 2.6012 45.7080 45.7065 46.2153 45.9427 45.6760 45.5209 45.4198 45.4259 45.5403 45.6702 45.8923 46.2033 46.1294 46.1281 46.1524 46.1712 456100.0000 457080.0054 457065.4948 462152.7306 459427.3219 456759.9615 455208.7493 454197.9305 454258.7466 455402.9621 456701.5888 458923.0163 462032.7928 461294.3869 461280.8739 461523.6276 461711.7362

01/11/2004 45.4100 12.0831 -0.2000 01/12/2004 44.4700 11.8610 -1.1400 03/01/2005 43.6100 11.5500 -2.0000 01/02/2005 43.6800 11.6239 -1.9300 01/03/2005 43.7200 11.6252 -1.8900 04/04/2005 43.7600 11.6009 -1.8500 02/05/2005 43.5700 11.5821 -2.0400

53

BETA RETURN BETA RETURN Swaps:

-2644.1507 7791121.9251 -14.1527

Table no 23:- Receiving dollars and hedging the position by swap contract CINF OF CINF OF EXCHANGE MARKET CF AFTER DATE INDIAN FIRM US FIRM RATES EX RATE CONVERSION 01/01/2004 $10,000.0000 456100.0000 03/02/2004 $10,000.0000 456100.0000 01/03/2004 $10,000.0000 456100.0000 02/04/2004 $10,000.0000 456100.0000 03/05/2004 $10,000.0000 456100.0000 01/06/2004 $10,000.0000 456100.0000 01/07/2004 $10,000.0000 456100.0000 02/08/2004 $10,000.0000 456100.0000 01/09/2004 $10,000.0000 456100.0000 01/10/2004 $10,000.0000 456100.0000 01/11/2004 $10,000.0000 456100.0000 01/12/2004 $10,000.0000 456100.0000 03/01/2005 $10,000.0000 456100.0000 01/02/2005 $10,000.0000 456100.0000 01/03/2005 $10,000.0000 456100.0000 04/04/2005 $10,000.0000 456100.0000 02/05/2005 $10,000.0000 456100.0000 45.6100 45.6100 45.6100 45.6100 45.6100 45.6100 45.6100 45.6100 45.6100 45.6100 45.6100 45.6100 45.6100 45.6100 45.6100 45.6100 45.6100 45.6100 45.3000 45.2400 43.7700 44.9700 45.4500 45.8800 46.3600 46.3300 45.9200 45.4100 44.4700 43.6100 43.6800 43.7200 43.7600 43.5700 456100.0000 456100.0000 456100.0000 456100.0000 456100.0000 456100.0000 456100.0000 456100.0000 456100.0000 456100.0000 456100.0000 456100.0000 456100.0000 456100.0000 456100.0000 456100.0000 456100.0000

54

BETA RETURN BETA RETURN Risk sharing:

0.0000 7753700.0000 0.0000

Lets assume a band 45 to 46, if the exchange rate is between the band it is directly converted or the risk is equally shared. Table no 24:- Receiving dollars and hedging the position with the help of risk sharing DOLLAR DATE RATE $ INFLOWS NET INFLOWS 01/01/2004 03/02/2004 01/03/2004 02/04/2004 03/05/2004 01/06/2004 01/07/2004 02/08/2004 01/09/2004 01/10/2004 01/11/2004 01/12/2004 03/01/2005 01/02/2005 01/03/2005 04/04/2005 02/05/2005 45.6100 45.3000 45.2400 43.7700 44.9700 45.4500 45.8800 46.3600 46.3300 45.9200 45.4100 44.4700 43.6100 43.6800 43.7200 43.7600 43.5700 10000.0000 10000.0000 10000.0000 10000.0000 10000.0000 10000.0000 10000.0000 10000.0000 10000.0000 10000.0000 10000.0000 10000.0000 10000.0000 10000.0000 10000.0000 10000.0000 10000.0000 456100.0000 453000.0000 452400.0000 443850.0000 449850.0000 454500.0000 458800.0000 461800.0000 461650.0000 459200.0000 454100.0000 447350.0000 443050.0000 443400.0000 443600.0000 443800.0000 442850.0000

BETA

6369.6519

55

RETURN BETA RETURN

7669300.0000 -13.2503

A) Paying dollars and its effects With out hedge: Table no 25:- Paying dollars and not hedging the position. DOLLAR DATE RATE CF CF IN RS 01/01/2004 45.6100 10000.0000 456100.0000 03/02/2004 45.3000 10000.0000 453000.0000 01/03/2004 45.2400 10000.0000 452400.0000 02/04/2004 43.7700 10000.0000 437700.0000 03/05/2004 44.9700 10000.0000 449700.0000 01/06/2004 45.4500 10000.0000 454500.0000 01/07/2004 45.8800 10000.0000 458800.0000 02/08/2004 46.3600 10000.0000 463600.0000 01/09/2004 46.3300 10000.0000 463300.0000 01/10/2004 45.9200 10000.0000 459200.0000 01/11/2004 45.4100 10000.0000 454100.0000 01/12/2004 44.4700 10000.0000 444700.0000 03/01/2005 43.6100 10000.0000 436100.0000 01/02/2005 43.6800 10000.0000 436800.0000 01/03/2005 43.7200 10000.0000 437200.0000 04/04/2005 43.7600 10000.0000 437600.0000 02/05/2005 43.5700 10000.0000 435700.0000

BETA COST BETA RETURN

9411.7647 7630500.0000 13.0900

Hedge with a forward contract: Table no 26:- Paying dollars and hedging the position with a forward contract.

56

DATE 01/01/2004 03/02/2004 01/03/2004 02/04/2004 03/05/2004 01/06/2004 01/07/2004 02/08/2004 01/09/2004 01/10/2004 01/11/2004 01/12/2004 03/01/2005 01/02/2005 01/03/2005 04/04/2005 02/05/2005

FORWARD RATE (IRP) 45.6100 45.7469 45.8838 46.0207 46.1576 46.2945 46.4314 46.5683 46.7052 46.8421 46.9790 47.1159 47.2528 47.3897 47.5266 47.6635 47.8004

FORWARD RATE (PPP) 45.6100 45.7172 45.8244 45.9316 46.0387 46.1459 46.2531 46.3603 46.4675 46.5747 46.6818 46.7890 46.8962 47.0034 47.1106 47.2178 47.3249

FORWARD $ RS RATE INFLOWS INFLOWS 45.6100 45.7320 45.8541 45.9761 46.0982 46.2202 46.3422 46.4643 46.5863 46.7084 46.8304 46.9525 47.0745 47.1965 47.3186 47.4406 47.5627 10000.0000 456100.0000 10000.0000 457320.4096 10000.0000 458540.8192 10000.0000 459761.2287 10000.0000 460981.6383 10000.0000 462202.0479 10000.0000 463422.4575 10000.0000 464642.8670 10000.0000 465863.2766 10000.0000 467083.6862 10000.0000 468304.0958 10000.0000 469524.5053 10000.0000 470744.9149 10000.0000 471965.3245 10000.0000 473185.7341 10000.0000 474406.1436 10000.0000 475626.5532

BETA COST BETA RETURN

-3213.4482 7919675.7022 51.6503

Hedge with an option: Table no 27:- Paying dollars and hedging the position with an option contract. COST IF COST IF $ OPTION OPTION STRIKE COST ON DATE RATES EXPIRES PREMIUM ACT PRICE $INFLOWS EXPIRATION

57

01/01/2004 45.6100 03/02/2004 45.3000 01/03/2004 45.2400 02/04/2004 43.7700 03/05/2004 44.9700 01/06/2004 45.4500 01/07/2004 45.8800 02/08/2004 46.3600 01/09/2004 46.3300 01/10/2004 45.9200 01/11/2004 45.4100 01/12/2004 44.4700 03/01/2005 43.6100 01/02/2005 43.6800 01/03/2005 43.7200 04/04/2005 43.7600 02/05/2005 43.5700 49.4011 49.0614 47.4862 47.6614 48.8588 49.5478 50.2565 50.4927 49.9965 49.1421 47.8003 46.2796 45.7721 45.8000 45.8104 45.5909 4.1011 3.8214 3.7162 2.6914 3.4088 3.6678 3.8965 4.1627 4.0765 3.7321 3.3303 2.6696 2.0921 2.0800 2.0504 2.0209

45.6100 45.2108 45.0408 45.0453 44.1302 44.9573 45.3261 45.6644 46.0403 46.0638 45.8292 45.5371 44.9861 44.5183 44.6159 44.6959 44.7762

10000.0000 41.1097 10000.0000 41.2194 10000.0000 41.3291 10000.0000 41.4388 10000.0000 41.5485 10000.0000 41.6582 10000.0000 41.7679 10000.0000 41.8776 10000.0000 41.9874 10000.0000 42.0971 10000.0000 42.2068 10000.0000 42.3165 10000.0000 42.4262 10000.0000 42.5359 10000.0000 42.6456 10000.0000 42.7553 10000.0000

456100.0000 452108.0373 450407.7286 450453.3362 441302.1707 449573.0393 453260.6740 456644.3322 460403.2764 460638.3284 458292.0724 455370.8436 449860.9064 445182.5519 446158.8220 446959.4097 447761.7683

BETA COST BETA RETURN Risk shifting:

3515.0011 7680477.2974 20.8315

Table no 28:- Paying dollars and hedging the position by shifting the risk. DATE 01/01/2004 DOLLAR RATE 45.6100 CF 456100.0000

58

03/02/2004 01/03/2004 02/04/2004 03/05/2004 01/06/2004 01/07/2004 02/08/2004 01/09/2004 01/10/2004 01/11/2004 01/12/2004 03/01/2005 01/02/2005 01/03/2005 04/04/2005 02/05/2005

45.3000 45.2400 43.7700 44.9700 45.4500 45.8800 46.3600 46.3300 45.9200 45.4100 44.4700 43.6100 43.6800 43.7200 43.7600 43.5700

456100.0000 456100.0000 456100.0000 456100.0000 456100.0000 456100.0000 456100.0000 456100.0000 456100.0000 456100.0000 456100.0000 456100.0000 456100.0000 456100.0000 456100.0000 456100.0000

BETA COST BETA RETURN Exposure netting

0.0000 7753700.0000 0.0000

1) Assuming we are paying dollar so with Australian dollar we go short Table no 29:- Paying dollars and hedging the position by exposure netting. DOLLAR AUS $ RETURN RETURN NET EFFECTIVE NET DATE RATE RATES ON $ ON AUS $ RETURN $ RATE INFLOWS 01/01/2004 45.6100 03/02/2004 45.3000 34.2349 34.2466 -0.3100 0.0117 -0.2983 45.6100 45.0017 456100.0000 450017.2426 59

01/03/2004 45.2400 02/04/2004 43.7700 03/05/2004 44.9700 01/06/2004 45.4500 01/07/2004 45.8800 02/08/2004 46.3600 01/09/2004 46.3300 01/10/2004 45.9200 01/11/2004 45.4100 01/12/2004 44.4700 03/01/2005 43.6100 01/02/2005 43.6800 01/03/2005 43.7200 04/04/2005 43.7600 02/05/2005 43.5700

34.9162 33.2557 31.9591 32.3834 32.0718 32.5521 32.5627 33.3444 33.9098 34.3171 33.8295 33.7724 34.5423 33.5008 33.8868

-0.3700 -1.8400 -0.6400 -0.1600 0.2700 0.7500 0.7200 0.3100 -0.2000 -1.1400 -2.0000 -1.9300 -1.8900 -1.8500 -2.0400

0.6814 -0.9791 -2.2758 -1.8514 -2.1630 -1.6828 -1.6722 -0.8904 -0.3251 0.0822 -0.4054 -0.4625 0.3075 -0.7340 -0.3480

0.3114 -2.8191 -2.9158 -2.0114 -1.8930 -0.9328 -0.9522 -0.5804 -0.5251 -1.0578 -2.4054 -2.3925 -1.5825 -2.5840 -2.3880

45.5514 40.9509 42.0542 43.4386 43.9870 45.4272 45.3778 45.3396 44.8849 43.4122 41.2046 41.2875 42.1375 41.1760 41.1820

455513.5004 409508.8554 420542.4128 434385.6861 439869.8985 454272.3225 453778.3209 453395.9707 448849.4885 434122.3883 412046.4825 412875.2312 421374.6326 411759.8644 411819.6695

BETA COST BETA RETURN

15378.4124 7380231.9669 24.2852

2) Assuming we r paying dollar we are going long on Saudi Arabian riyal Table no 30:- Paying dollars and hedging the position by exposure netting. DOLLAR SA RETURN RETURN NET EFFECTIVE NET DATE RATE RIYAL ON $ ON SA R RETURN $ RATE INFLOWS 01/01/2004 03/02/2004 01/03/2004 45.6100 12.143 45.3000 12.0453 -0.3100 45.2400 12.0467 -0.3700 0.0980 0.0965 0.4080 0.4665 45.7080 45.7065 456100.000 457080.005 457065.4948

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02/04/2004 03/05/2004 01/06/2004 01/07/2004 02/08/2004 01/09/2004 01/10/2004 01/11/2004 01/12/2004 03/01/2005 01/02/2005 01/03/2005 04/04/2005 02/05/2005

43.7700 11.5380 -1.8400 44.9700 11.8106 -0.6400 45.4500 12.0773 -0.1600 45.8800 12.2324 0.2700 46.3600 12.3335 0.7500 46.3300 12.3274 0.7200 45.9200 12.2130 0.3100 45.4100 12.0831 -0.2000 44.4700 11.8610 -1.1400 43.6100 11.5500 -2.0000 43.6800 11.6239 -1.9300 43.7200 11.6252 -1.8900 43.7600 11.6009 -1.8500 43.5700 11.5821 -2.0400

0.6053 0.3327 0.0660 -0.0891 -0.1902 -0.1841 -0.0697 0.0602 0.2823 0.5933 0.5194 0.5181 0.5424 0.5612

2.4453 0.9727 0.2260 -0.3591 -0.9402 -0.9041 -0.3797 0.2602 1.4223 2.5933 2.4494 2.4081 2.3924 2.6012

46.2153 45.9427 45.6760 45.5209 45.4198 45.4259 45.5403 45.6702 45.8923 46.2033 46.1294 46.1281 46.1524 46.1712

462152.7306 459427.3219 456759.9615 455208.7493 454197.9305 454258.7466 455402.9621 456701.5888 458923.0163 462032.7928 461294.3869 461280.8739 461523.6276 461711.7362

BETA RETURN BETA RETURN Swaps:

-2644.1507 7791121.9251 14.1527

Table no 31:- Paying dollars and hedging the position by a swap contract. CINF OF INDIAN CINF OF EXCHANGE MARKET CF AFTER DATE FIRM US FIRM RATES EX RATE CONVERSION 456100.000 01/01/2004 $10,000.0000 0 45.6100 45.6100 456100.0000 456100.000 03/02/2004 $10,000.0000 0 45.6100 45.3000 456100.0000 456100.000 01/03/2004 $10,000.0000 0 45.6100 45.2400 456100.0000

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02/04/2004 $10,000.0000 03/05/2004 $10,000.0000 01/06/2004 $10,000.0000 01/07/2004 $10,000.0000 02/08/2004 $10,000.0000 01/09/2004 $10,000.0000 01/10/2004 $10,000.0000 01/11/2004 $10,000.0000 01/12/2004 $10,000.0000 03/01/2005 $10,000.0000 01/02/2005 $10,000.0000 01/03/2005 $10,000.0000 04/04/2005 $10,000.0000 02/05/2005 $10,000.0000

456100.000 0 456100.000 0 456100.000 0 456100.000 0 456100.000 0 456100.000 0 456100.000 0 456100.000 0 456100.000 0 456100.000 0 456100.000 0 456100.000 0 456100.000 0 456100.000 0

45.6100 45.6100 45.6100 45.6100 45.6100 45.6100 45.6100 45.6100 45.6100 45.6100 45.6100 45.6100 45.6100 45.6100

43.7700 44.9700 45.4500 45.8800 46.3600 46.3300 45.9200 45.4100 44.4700 43.6100 43.6800 43.7200 43.7600 43.5700

456100.0000 456100.0000 456100.0000 456100.0000 456100.0000 456100.0000 456100.0000 456100.0000 456100.0000 456100.0000 456100.0000 456100.0000 456100.0000 456100.0000

BETA RETURN BETA RETURN Risk sharing:

0.0000 7753700.0000 0.0000

Table no 32:- Paying dollars and hedging the position with the contract of risk sharing. DOLLAR DATE RATE $ INFLOWS NET INFLOWS 01/01/2004 03/02/2004 45.6100 45.3000 10000.0000 10000.0000 456100.0000 453000.0000

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01/03/2004 02/04/2004 03/05/2004 01/06/2004 01/07/2004 02/08/2004 01/09/2004 01/10/2004 01/11/2004 01/12/2004 03/01/2005 01/02/2005 01/03/2005 04/04/2005 02/05/2005

45.2400 43.7700 44.9700 45.4500 45.8800 46.3600 46.3300 45.9200 45.4100 44.4700 43.6100 43.6800 43.7200 43.7600 43.5700

10000.0000 10000.0000 10000.0000 10000.0000 10000.0000 10000.0000 10000.0000 10000.0000 10000.0000 10000.0000 10000.0000 10000.0000 10000.0000 10000.0000 10000.0000

452400.0000 443850.0000 449850.0000 454500.0000 458800.0000 461800.0000 461650.0000 459200.0000 454100.0000 447350.0000 443050.0000 443400.0000 443600.0000 443800.0000 442850.0000

BETA RETURN BETA RETURN

6369.6519 7669300.0000 13.2503

INTERPRETATION: From the above calculation we could see that if the above contract is not hedge the beta return (excess return over the beta) could range from 13.09 to +13.09 as the currency is appreciating in the period it would be beneficial to the importer making pay less against the dollar.

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If hedged with the forward contract the return on the dollar (return on currency) would change to a greater extent, which would be offset against the profit on the contract, which has araised as a result of inflation in the market. The option has proved costlier against the other hedging techniques, which has decreased the beta return to 97 and increased to 20. As stated earlier much emphasis need to given for the selection of the strike price, which could reduce the marginal cost over the contract. The swaps and risk shifting could actually eliminate the entire currency risk. And they are not free from there own demerits. By netting the currency exposure the firm can reduce it risk but it would an added advantage to the firm if they use an additional tool to recover from the currency exposure to a greater extent. By risk sharing the beta return went up to as a small percentage. As there is nothing small in the real world this would also be an useful tool.

TESTING OF HYPOTHESIS An paired-samples t-test was conducted on 100 random samples of 17 inflows (varying over each period) obtained by simulation, to find out which tools best suits for the firm while receiving the foreign currencies and paying them. The test came out with the following results: For outflows of foreign currencies (importer): Table no 33:- Various mean when there are outflows of currencies

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TOOL WITHOUT FORWARD OPTION RISKSHIF EXPO1 EXPO2 SWAPS RISKSHAR

MEAN 0.1328 2.4740 25.0640 0.0000 697.7514 1.7785 0.0000 -8.5772

N 100 100 100 100 100 100 100 100

STD. DEVIATION 26.9186 22.9394 131.3993 0.0000 5500.9226 13.5047 0.0000 96.1886

STD. ERROR MEAN 2.6919 2.2939 13.1399 0.0000 550.0923 1.3505 0.0000 9.6189

For inflows of foreign currencies (exporter): Table no 34:- Various mean when there are inflows of currencies TOOL WITHOUT FORWARD OPTION RISKSHIF EXPO1 EXPO2 SWAPS MEAN -12.0754 -4.4680 -23.7592 0.0000 7.8819 -34.1929 0.0000 N 100 100 100 100 100 100 100 100 STD. DEVIATION 77.5717 36.1080 319.5661 0.0000 53.6712 334.8398 0.0000 37.1053 STD. ERROR MEAN 7.7572 3.6108 31.9566 0.0000 5.3671 33.4840 0.0000 3.7105

RISKSHAR -1.4521 Paired t test results: -

H0: no difference in excess returns to beta for the pair of tools H1: difference in excess returns to beta for the pair of tools For outflows of foreign currencies (importer): Table no 35:- t-test results for outflows of foreign currencies TOOL WITHOUT - FORWARD WITHOUT - OPTION T -0.678742 -1.905885 DF 99 99 SIG. (2-TAILED) 0.498885 0.059566 65

PAIR 1 PAIR 2

PAIR 3 PAIR 4 PAIR 5 PAIR 6 PAIR 7 PAIR 8 PAIR 9 PAIR 10 PAIR 11 PAIR 12 PAIR 13 PAIR 14 PAIR 15 PAIR 16 PAIR 17 PAIR 18 PAIR 19 PAIR 20 PAIR 21 PAIR 22 PAIR 23 PAIR 24 PAIR 25 PAIR 26

WITHOUT - RISKSHIF WITHOUT - EXPO1 WITHOUT - EXPO2 WITHOUT - SWAPS WITHOUT - RISKSHAR FORWARD - OPTION FORWARD - RISKSHIF FORWARD - EXPO1 FORWARD - EXPO2 FORWARD - SWAPS FORWARD - RISKSHAR OPTION - RISKSHIF OPTION - EXPO1 OPTION - EXPO2 OPTION - SWAPS OPTION - RISKSHAR RISKSHIF - EXPO1 RISKSHIF - EXPO2 RISKSHIF - RISKSHAR EXPO1 - EXPO2 EXPO1 - SWAPS EXPO1 - RISKSHAR EXPO2 - SWAPS EXPO2 - RISKSHAR

0.049326 -1.267581 -0.558719 0.049326 0.838995 -1.742533 1.078489 -1.264093 0.514383 1.078489 1.104226 1.907467 -1.222617 1.760475 1.907467 2.037315 -1.268426 -1.316912 0.891702 1.265198 1.268426 1.283794 1.316912 1.06548 0.891702

99 99 99 99 99 99 99 99 99 99 99 99 99 99 99 99 99 99 99 99 99 99 99 99 99

0.960759 0.207921 0.577615 0.960759 0.403493 0.08452 0.283436 0.209165 0.608131 0.283436 0.272172 0.059358 0.224377 0.081416 0.059358 0.044287 0.20762 0.190908 0.374715 0.20877 0.20762 0.202211 0.190908 0.28925 0.374715

PAIR 27 SWAPS - RISKSHAR For inflows of foreign currencies (exporter): -

Table no 36:- t-test results for outflows of foreign currencies TOOL PAIR 1 PAIR 2 PAIR 3 PAIR 4 PAIR 5 PAIR 6 PAIR 7 WITHOUT - FORWARD WITHOUT - OPTION WITHOUT - RISKSHIF WITHOUT - EXPO1 WITHOUT - EXPO2 WITHOUT - SWAPS WITHOUT - RISKSHAR T -0.908473 0.352706 -1.556678 -2.427651 0.643171 -1.556678 -1.182046 DF 99 99 99 99 99 99 99 SIG. (2-TAILED) 0.365835 0.725059 0.122738 0.017003 0.5216 0.122738 0.240019

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PAIR 8 PAIR 9 PAIR 10 PAIR 11 PAIR 12 PAIR 13 PAIR 14 PAIR 15 PAIR 16 PAIR 17 PAIR 18 PAIR 19 PAIR 20 PAIR 21 PAIR 22 PAIR 23 PAIR 24 PAIR 25 PAIR 26 PAIR 27 FINDING: -

FORWARD - OPTION FORWARD - RISKSHIF FORWARD - EXPO1 FORWARD - EXPO2 FORWARD - SWAPS FORWARD - RISKSHAR OPTION - RISKSHIF OPTION - EXPO1 OPTION - EXPO2 OPTION - SWAPS OPTION - RISKSHAR RISKSHIF - EXPO1 RISKSHIF - EXPO2 RISKSHIF - RISKSHAR EXPO1 - EXPO2 EXPO1 - SWAPS EXPO1 - RISKSHAR EXPO2 - SWAPS EXPO2 - RISKSHAR SWAPS - RISKSHAR

0.632998 -1.237409 -1.938469 0.963917 -1.237409 -0.594691 -0.743484 -0.984841 0.260387 -0.743484 -0.693788 -1.468554 1.021171 0.391345 1.250582 1.468554 1.475425 -1.021171 -0.973909 0.391345

99 99 99 99 99 99 99 99 99 99 99 99 99 99 99 99 99 99 99 99

0.528195 0.218862 0.055414 0.337436 0.218862 0.553407 0.45895 0.327103 0.795106 0.45895 0.48944 0.145124 0.309662 0.696384 0.214035 0.145124 0.143272 0.309662 0.332475 0.696384

The standard deviation of options and risk sharing being high for the outflow of funds means that they are more risky. After swaps and risk-shifting, forwards had the least standard deviation. On the receiving end, exposure-netting and options had a higher standard deviation. Forwards and risk-sharing proved to be better tools. As the result of t-test, options were proved to give a better beta return (excess return over beta) over exposure netting, swaps, risk-sharing and risk-shifting for the paying part of foreign currencies.

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 Forwards was found to be a better tool against options, exposure netting and risk sharing on the receiving part of foreign currencies. The test conducted on total inflows and outflows got the following results which could be ranked as bellow: Table no 37:- Ranking of the various tools RANK 1 2 3 4 5 6 7 8 TOOL OPTION FORWARD EXPOSURE NETTING-2 RISKSHIF SWAPS RISKSHAR WITHOUT EXPOSURE NETTING-1 MEAN 8162521 7918551 7790009 7753700 7753700 7672126 7634603 7385539

SUGGESTIONS: The firm has to check the inflation rates and the interest rates before making sure that the forward rates are properly priced to make better hedge and also take advantage if there is any mispricing. We could suggest that if the firm does not want its return to deviate it could go in for forwards, risk shifting and swaps. If the firm wants to take risk and want a better return over its beta it could go for options when it is paying its foreign currencies. Forwards were found to be the best over many other tools and so we could suggest forwards to be a better tool.

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CONCLUSION: In the world of globalization were one company would be operating in more than one country. And receiving for exports and paying for imports in foreign currencies would be the part of every business organization it is a healthy option for any company to hedge its foreign outflows and inflows. It could be suggested that with a well-regulated foreign exchange market it would be a better thing to hedge its inflows and outflows otherwise making the currency exposure to eat away its entire profits. This project helped me to understand the foreign exchange market, the movement of currency prices in the market and its impact over the companies, which does international trade. It also helped me to learn the various concepts like purchasing power parity, options, forwards etc

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