Foreign Exchange Risk Management

1. By Mr. Manis Thanawala Director Greenback Forex Services Pvt. Ltd Foreign Exchange Risk Management

2. Introduction • What is Risk? Defined as the volatility of unexpected events • What is Currency Risk? Risk that the currency rates will move in the adverse direction. Example : In case of USD/INR, if USD appreciates the Indian Importer would be at a loss and if USD depreciates the Indian Exporter would be at loss.

3. Why does USD/INR Fluctuate??? • FII • FDI • Relaxation in ECB norms • Increase/decrease in CRR, Repo Rate, etc. • GDP • Inflation • Crude oil prices • Weakening of Thai Baht • Collapse of Korean Won • Terror attacks • Change in Govt

4. Peculiarities of USD/INR • USD/INR largely affected by international factors • Gap - up and gap - down openings

5. Need to manage risks • Insure against adverse exchange rates • Protect operating profits • Optimizing exchange gains • Contain losses • Volatile and uncertain forex markets • Cost Reduction • Achieve budgets and targets • Maintain sustainable business in light of stiff competition

6. Approaches to Risk Management

7. Hedging Tools • Forwards A contract to buy or sell currencies at a future specific date (beyond spot), at a rate negotiated at the time of entering into the contract. • Futures A currency future, also FX future or foreign exchange future, is a futures contract to exchange one currency for another at a specified date in the future at a price (exchange rate) that is fixed on the purchase date. Typically, one of the currencies is the US Dollar and the other is INR. • Options A contract which provides to the buyer “right but not the obligation, to buy or sell a specific asset at a specific price, on or before any time prior to the specific date.”

8. Currency Futures – An Edge over Forwards • Transparency – in terms of price prevailing at the time of booking the contract • Narrow Bid-Ask Spread • No underlying required for booking in this platform • Eliminates counterparty credit risk (Exchange is the counterparty) • High accessibility throughout the exchange timings

9. Currency Futures – An Edge over Forwards • Convenience of operations as compared to OTC market • Mark to market profit is realized on the same day unlike the OTC market where it is realized on maturity • No distinction between large and small customers or amounts • One time documentation (No documents to be provided at time of booking)

10. Cons of Currency Futuresof Cur • Margin based Hedge • Maturity Mismatch - Resulting to Basis Risk • Negative cash flow due to out of the money MTM • Settlement in cash on Maturity • Less Liquidity for far month contracts

11. Forwards v/s Futures

12. Case Study Spot rate on 16th Dec 2010 : 45.35-45.36 USD/INR 27th Jan 2011 Contract : 45.7000-45.7025 Using futures to hedge currency risk for corporate Transaction An exporter has executed an export order and the money is to be received on 25th Jan 2011, say USD 100,000. USD/INR was as 45.00 when contract was executed. Hedge Strategy Sell 100 contracts of each expiry 27th Jan 2011 @ 45.7000

13. Payoff of hedge vis-à-vis the transaction On date of receipt of payment i.e. 25th Jan 2011 Scenario I Spot: 44.70 Amount realized in OTC @ 44.70 P/L on Exchange: 45.70 – 44.70 = INR 1.00 (Profit) (Provided canceled at the same time when realized in OTC) Hence, hedged at 44.70 + 1.00 = 45.70

14. Payoff of hedge vis-à-vis the transaction On date of receipt of payment i.e. 25th January 2010 Scenario II Spot: 46.70 Amount realizes in OTC @ 46.70 P/L on Exchange: 45.70 – 46.70 = INR 1.00 (Loss) (Provided canceled at the same time when realized in OTC) Hence, hedged at 46.70 – 1.00 = 45.70 So even if rupee moves either way corporate is hedged against currency fluctuation

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