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INDEX
ABSTRACT
. The study is done with reference to HDFC Bank Ltd, is an Indian financial services company based in Mumbai, Maharashtra that was incorporated in August 1994. The operations studied include foreign exchange trading - bulk purchases, bulk sales, retail purchases or encashment and retail sales of currencies, Travelers Cheques, World Money Cards of major international currencies. The project also aims at studying management of franchisees, agents, management of funds for daily operations, settlements with banks. The other operations studied include inverting remittance to Western Union, providing Telephonic Transfer (T.T) service, acquisition of new clients, documentation of various requisites of the transactions done by FFMCs, reporting activities. The scope of the study also encompasses study on forex market participants, factors affecting forex markets. Major currencies are taken for the study. The project involved taking part in daily transactions of bulk purchases, bulk sales, retail purchases, retail sales, handling the transactions through software package, currency tallying and settlements at the end of the day.
CHAPTER-I
INTRODUCTION
INTRODUCTION
Foreign Exchange is the purchase or sale of one nation’s currency in exchange for another nation’s currency.Foreign Exchange makes possible international transactions such as imports and exports and the movement of capital between countries.
Foreign Exchange is the money in one country for money or credit or goods or services in another country.Foreign Exchange includes foreign currencies, foreign cheques and foreign drafts.
Foreign Exchange is the transaction of international monetary business, as between governments or businesses of different countries.
Foreign Exchange is the negotiable bills drawn in one country to be paid in another country.
Foreign Exchange is any currency other than the local currency which is used in settling international transactions.
Foreign Exchange is the system of trading in and converting the currency of one country into that of another country.
Foreign Exchange is the transfer of credits to a foreign country to settle debts or accounts between residents of the home country and those of the foreign country.
Definition of Foreign Exchange:
The foreign capital earned by a country’s exports.Since the currency of many less developed countries is not accepted by international markets, it often becomes necessary to earn foreign exchange in order to buy imports.
-Geography Dictionary
Foreign exchange exposure and risk are important concept in the study of international finance. It is the sensitivity of the home currency value of asset, liabilities, or operating incomes to unanticitpated changes in the exchange rates.
Exposure exists if the home currency values on an average in a particular manner. It also exists where numerous currencies are involved.
Foreign exchange risk is the variance of the home currency value of items arising on account of unanticipated changes in the exchange rates.
The derivative instruments like forwards, futures and options are used to hedge against the foreign exchange risk of the Multinational companies.
The original derivatives contract of International Finance is the ‘Forward exchange contract’. Forward Foreign exchange is a traditional and popular risk management tool to obtain protection against adverse exchange rate movements. The exchange rate is ‘locked in’ for a specific date in future, which enables the person involved in the contract to plan for and budget the business expenses with more certainty.
Forward exchange market, has since the 1960s, played the role of linking international interest rates. Today, however, Forward contract have to share other instruments and markets for arbitrage and for hedging. These newer derivative instruments include Futures, Options and Swaps.
Scope of the study:-
• To know what is foreign exchange and what are the various foreign exchange services.
• To know how the transactions related to foreign exchange volatility carried out.
• To have a brief knowledge about various foreign currencies and their exchange rates compare to other nations currencies.
NEED AND IMPORTANCE OF THE STUDY
The world nations are increasingly becoming more interrelated global trade, and global investment. These international result in cross country flow of world nations. Countries hold currencies of other countries and that a market, dealing of foreign exchange results.
Foreign exchange means reserves of foreign currencies. More aptly, foreign exchange refers to claim to foreign money balances. Foreign exchange gives resident of one country a financial claim on other country or countries. All deposits, credits and balances payable in foreign currency and any drafts, travelers’ cheques, letters of credit and bills of exchange payable in foreign currency constitute foreign exchange. Foreign exchange market is the market where money denominated in one currency is bought and sold with money denominated in another currency. Transactions in currencies of countries, parties to these transactions, rates at which one currency is exchanged for other or others, ramification in these rates, derivatives to the currencies and dealing in them and related aspects constitute the foreign exchange (in short, forex) market.
Foreign exchange transactions take place whenever a country imports goods and services, people of a country undertake visits to other counties, citizens of a country remit money abroad for whatever purpose, business units set up foreign subsidiaries and so on. In all these cases the nation concerned buys relevant and required foreign exchange, in exchange of its currency, or draws from foreign exchange reserves built. On the other hand, when a country exports goods and services to another country, when people of other countries visit the country, when citizens of the country settled abroad remit money homewards, when foreign citizens, firms and institutions invest in the country and when the country or its business community raises funds from abroad, the country’s currency is bought by others, giving foreign exchange, in exchange. Multinational firms operate in more than one country and their operations involve multiple foreign currencies. Their operations are influenced by politics and the laws of the counties where they operate. Thus, they face higher degree of risk as compared to domestic firms. A matter of great concern for the international firms is to analyze the implications of the changes in interest rates, inflation rates and exchange rates on their decisions and minimize the foreign exchange risk. The importance of the study is to know the features of foreign exchange and the factors creating risk in foreign exchange transactions and the techniques used for managing that risk.
OBJECTIVES OF THE STUDY
▪ To study and understand the foreign exchange in HDFC Limited.
▪ To study and analyze the revenues of the company when the exchange rates fluctuate.
▪ To analyze income statement and find out the revenues when the dollars are converted into Indian rupees.
▪ To study the different types of foreign exchange exposure including risk and risk management techniques which the company is used to minimize the risk.
▪ To present the findings and conclusions of the company in respect of foreign exchange risk management
SOURCES OF DATA
Primary data:
The primary data information is gathered from HDFC Limited executives.
Secondary data:
The secondary data is collected from various financial books, magazines and Hdfc Bank Ltd as part of the training class undertaken for project.
LIMITATIONS
• The study is confined just to the foreign exchange risk but not the total risk.
• The analysis of this study is mainly done on the income statements.
• This study is limited for the year 2011-2012.
• It does not take into consideration all Indian companies foreign exchange risk.
• The hedging techniques are studied only which the company adopted to minimize foreign exchange risk.
CHAPTER-II
INDUSTRY PROFILE
&
COMPANY PROFILE
FOREIGN EXCHANGE MARKET
The foreign exchange market (forex, FX, or currency market) is a worldwide decentralized over-the-counter financial market for the trading of currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends. The foreign exchange market determines the relative values of different currencies.
The primary purpose of the foreign exchange is to assist international trade and investment, by allowing businesses to convert one currency to another currency. For example, it permits a US business to import British goods and pay Pound Sterling, even though the business's income is in US dollars. It also supports speculation, and facilitates the carry trade, in which investors borrow low-yielding currencies and lend (invest in) high-yielding currencies, and which (it has been claimed) may lead to loss of competitiveness in some countries.
In a typical foreign exchange transaction, a party purchases a quantity of one currency by paying a quantity of another currency. The modern foreign exchange market began forming during the 1970s when countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed as per the system. The foreign exchange market is unique because of
• its huge trading volume, leading to high liquidity;
• its geographical dispersion;
• its continuous operation: 24 hours a day except weekends, i.e. trading from 20:15 GMT on Sunday until 22:00 GMT Friday;
• the variety of factors that affect exchange rates;
• the low margins of relative profit compared with other markets of fixed income; and
• The use of leverage to enhance profit margins with respect to account size.
As such, it has been referred to as the market closest to the ideal of perfect competition, notwithstanding market manipulation by central banks According to the Bank for International Settlements, as of April 2010, average daily turnover in global foreign exchange markets is estimated at $3.98 trillion, a growth of approximately 20% over the $3.21 trillion daily volume as of April 2007.
The $3.98 trillion break-down is as follows:
• $1.490 trillion in spot transactions
• $475 billion in outright forwards
• $1.765 trillion in foreign exchange swaps
• $43 billion currency swaps
• $207 billion in options and other products
Market size and liquidity
The foreign exchange market is the largest and most liquid financial market in the world. Traders include large banks, central banks, currency speculators, corporations, governments, and other financial institutions. The average daily volume in the global foreign exchange and related markets is continuously growing. Daily turnover was reported to be over US$3.98 trillion in April 2010 by the Bank for International Settlements.
Of the $3.98 trillion daily global turnover, trading in London accounted for around $1.85 trillion, or 36.7% of the total, making London by far the global center for foreign exchange. In second and third places respectively, trading in New York City accounted for 17.9%, and Tokyo accounted for 6.2%. In addition to "traditional" turnover, $2.1 trillion was traded in derivatives.
Exchange-traded FX futures contracts were introduced in 1972 at the Chicago Mercantile Exchange and are actively traded relative to most other futures contracts.
Several other developed countries also permit the trading of FX derivative products (like currency futures and options on currency futures) on their exchanges. All these developed countries already have fully convertible capital accounts. Most emerging countries do not permit FX derivative products on their exchanges in view of prevalent controls on the capital accounts. However, a few select emerging countries have already successfully experimented with the currency futures exchanges, despite having some controls on the capital account.
FX futures volume has grown rapidly in recent years, and accounts for about 7% of the total foreign exchange market volume, according to The Wall Street Journal Europe (5/5/06, p. 20).
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Foreign exchange trading increased by over a third in the 12 months to April 2010 and has more than doubled since 2001. This is largely due to the growing importance of foreign exchange as an asset class and an increase in fund management assets, particularly of hedge funds and pension funds. The diverse selection of execution venues have made it easier for retail traders to trade in the foreign exchange market. In 2009, retail traders constituted over 5% of the whole FX market volumes (see retail trading platforms).
Because foreign exchange is an OTC market where brokers/dealers negotiate directly with one another, there is no central exchange or clearing house. The biggest geographic trading centre is the UK, primarily London, which according to TheCityUK estimates has increased its share of global turnover in traditional transactions from 34.6% in April 2007 to 36.7% in April 2010. Due to London's dominance in the market, a particular currency's quoted price is usually the London market price. For instance, when the IMF calculates the value of its SDRs every day, they use the London market prices at noon that day.
Market participants
Unlike a stock market, the foreign exchange market is divided into levels of access. At the top is the inter-bank market, which is made up of the largest commercial banks and securities dealers. Within the inter-bank market, spreads, which are the difference between the bid and ask prices, are razor sharp and usually unavailable, and not known to players outside the inner circle. The difference between the bid and ask prices widens (from 0-1 pip to 1-2 pips for some currencies such as the EUR). This is due to volume. If a trader can guarantee large numbers of transactions for large amounts, they can demand a smaller difference between the bid and ask price, which is referred to as a better spread. The levels of access that make up the foreign exchange market are determined by the size of the "line" (the amount of money with which they are trading). The top-tier inter-bank market accounts for 53% of all transactions. After that there are usually smaller banks, followed by large multi-national corporations (which need to hedge risk and pay employees in different countries), large hedge funds, and even some of the retail FX-metal market makers. According to Galati and Melvin, “Pension funds, insurance companies, mutual funds, and other institutional investors have played an increasingly important role in financial markets in general, and in FX markets in particular, since the early 2000s.” (2004) In addition, he notes, “Hedge funds have grown markedly over the 2001–2004 period in terms of both number and overall size” Central banks also participate in the foreign exchange market to align currencies to their economic needs.
Banks
The interbank market caters for both the majority of commercial turnover and large amounts of speculative trading every day. A large bank may trade billions of dollars daily. Some of this trading is undertaken on behalf of customers, but much is conducted by proprietary desks, trading for the bank's own account. Until recently, foreign exchange brokers did large amounts of business, facilitating interbank trading and matching anonymous counterparts for large fees. Today, however, much of this business has moved on to more efficient electronic systems. The broker squawk box lets traders listen in on ongoing interbank trading and is heard in most trading rooms, but turnover is noticeably smaller than just a few years ago.
Commercial companies
An important part of this market comes from the financial activities of companies seeking foreign exchange to pay for goods or services. Commercial companies often trade fairly small amounts compared to those of banks or speculators, and their trades often have little short term impact on market rates. Nevertheless, trade flows are an important factor in the long-term direction of a currency's exchange rate. Some multinational companies can have an unpredictable impact when very large positions are covered due to exposures that are not widely known by other market participants.
Central banks
National central banks play an important role in the foreign exchange markets. They try to control the money supply, inflation, and/or interest rates and often have official or unofficial target rates for their currencies. They can use their often substantial foreign exchange reserves to stabilize the market. Nevertheless, the effectiveness of central bank "stabilizing speculation" is doubtful because central banks do not go bankrupt if they make large losses, like other traders would, and there is no convincing evidence that they do make a profit trading.
Forex Fixing
Forex fixing is the daily monetary exchange rate fixed by the national bank of each country. The idea is that central banks use the fixing time and exchange rate to evaluate behavior of their currency. Fixing exchange rates reflects the real value of equilibrium in the forex market. Banks, dealers and online foreign exchange traders use fixing rates as a trend indicator.
The mere expectation or rumor of central bank intervention might be enough to stabilize a currency, but aggressive intervention might be used several times each year in countries with a dirty float currency regime. Central banks do not always achieve their objectives. The combined resources of the market can easily overwhelm any central bank. Several scenarios of this nature were seen in the 1992–93 ERM collapse, and in more recent times in Southeast Asia.
Hedge funds as speculators
About 70% to 90% of the foreign exchange transactions are speculative. In other words, the person or institution that bought or sold the currency has no plan to actually take delivery of the currency in the end; rather, they were solely speculating on the movement of that particular currency. Hedge funds have gained a reputation for aggressive currency speculation since 1996. They control billions of dollars of equity and may borrow billions more, and thus may overwhelm intervention by central banks to support almost any currency, if the economic fundamentals are in the hedge funds' favor.
Investment management firms
Investment management firms (who typically manage large accounts on behalf of customers such as pension funds and endowments) use the foreign exchange market to facilitate transactions in foreign securities. For example, an investment manager bearing an international equity portfolio needs to purchase and sell several pairs of foreign currencies to pay for foreign securities purchases.
Some investment management firms also have more speculative specialist currency overlay operations, which manage clients' currency exposures with the aim of generating profits as well as limiting risk. Whilst the number of this type of specialist firms is quite small, many have a large value of assets under management (AUM), and hence can generate large trades.
Retail foreign exchange brokers
Retail traders (individuals) constitute a growing segment of this market, both in size and importance. Currently, they participate indirectly through brokers or banks. Retail brokers, while largely controlled and regulated in the USA by the CFTC and NFA have in the past been subjected to periodic foreign exchange scams. To deal with the issue, the NFA and CFTC began (as of 2009) imposing stricter requirements, particularly in relation to the amount of Net Capitalization required of its members. As a result many of the smaller, and perhaps questionable brokers are now gone.
There are two main types of retail FX brokers offering the opportunity for speculative currency trading: brokers and dealers or market makers. Brokers serve as an agent of the customer in the broader FX market, by seeking the best price in the market for a retail order and dealing on behalf of the retail customer. They charge a commission or mark-up in addition to the price obtained in the market. Dealers or market makers, by contrast, typically act as principal in the transaction versus the retail customer, and quote a price they are willing to deal at—the customer has the choice whether or not to trade at that price.
In assessing the suitability of an FX trading service, the customer should consider the ramifications of whether the service provider is acting as principal or agent. When the service provider acts as agent, the customer is generally assured of a known cost above the best inter-dealer FX rate. When the service provider acts as principal, no commission is paid, but the price offered may not be the best available in the market—since the service provider is taking the other side of the transaction, a conflict of interest may occur.
Non-bank foreign exchange companies
Non-bank foreign exchange companies offer currency exchange and international payments to private individuals and companies. These are also known as foreign exchange brokers but are distinct in that they do not offer speculative trading but currency exchange with payments. I.e., there is usually a physical delivery of currency to a bank account. Send Money Home offers an in-depth comparison into the services offered by all the major non-bank foreign exchange companies.
It is estimated that in the UK, 14% of currency transfers/payments are made via Foreign Exchange Companies. These companies' selling point is usually that they will offer better exchange rates or cheaper payments than the customer's bank. These companies differ from Money Transfer/Remittance Companies in that they generally offer higher-value services.
Money transfer/remittance companies
Money transfer companies/remittance companies perform high-volume low-value transfers generally by economic migrants back to their home country. In 2007, the Aite Group estimated that there were $369 billion of remittances (an increase of 8% on the previous year). The four largest markets (India, China, Mexico and the Philippines) receive $95 billion. The largest and best known provider is Western Union with 345,000 agents globally followed by UAE Exchange & Financial Services Ltd.
Trading characteristics
Most traded currencies
Currency distribution of reported FX market turnover
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There is no unified or centrally cleared market for the majority of FX trades, and there is very little cross-border regulation. Due to the over-the-counter (OTC) nature of currency markets, there are rather a number of interconnected marketplaces, where different currencies instruments are traded. This implies that there is not a single exchange rate but rather a number of different rates (prices), depending on what bank or market maker is trading, and where it is. In practice the rates are often very close, otherwise they could be exploited by arbitrageurs instantaneously. Due to London's dominance in the market, a particular currency's quoted price is usually the London market price. A joint venture of the Chicago Mercantile Exchange and Reuters, called Fxmarketspace opened in 2007 and aspired but failed to the role of a central market clearing mechanism.
The main trading center is London, but New York, Tokyo, Hong Kong and Singapore are all important centers as well. Banks throughout the world participate. Currency trading happens continuously throughout the day; as the Asian trading session ends, the European session begins, followed by the North American session and then back to the Asian session, excluding weekends.
Fluctuations in exchange rates are usually caused by actual monetary flows as well as by expectations of changes in monetary flows caused by changes in gross domestic product (GDP) growth, inflation (purchasing power parity theory), interest rates (interest rate parity, Domestic Fisher effect, International Fisher effect), budget and trade deficits or surpluses, large cross-border M&A deals and other macroeconomic conditions. Major news is released publicly, often on scheduled dates, so many people have access to the same news at the same time. However, the large banks have an important advantage; they can see their customers' order flow.
Currencies are traded against one another. Each currency pair thus constitutes an individual trading product and is traditionally noted XXXYYY or XXX/YYY, where XXX and YYY are the ISO 4217 international three-letter code of the currencies involved. The first currency (XXX) is the base currency that is quoted relative to the second currency (YYY), called the counter currency (or quote currency). For instance, the quotation EURUSD (EUR/USD) 1.5465 is the price of the euro expressed in US dollars, meaning 1 euro = 1.5465 dollars. Historically, the base currency was the stronger currency at the creation of the pair. However, when the euro was created, the European Central Bank mandated that it always be the base currency in any pairing.
The factors affecting XXX will affect both XXXYYY and XXXZZZ. This causes positive currency correlation between XXXYYY and XXXZZZ.
On the spot market, according to the BIS study, the most heavily traded products were:
• EURUSD: 27%
• USDJPY: 13%
• GBPUSD (also called cable): 12%
and the US currency was involved in 84.39% of transactions, followed by the euro (39.1%), the yen (19.0%), and sterling (12.9%) .Volume percentages for all individual currencies should add up to 200%, as each transaction involves two currencies.
Trading in the euro has grown considerably since the currency's creation in January 1999, and how long the foreign exchange market will remain dollar-centered is open to debate. Until recently, trading the euro versus a non-European currency ZZZ would have usually involved two trades: EURUSD and USDZZZ. The exception to this is EURJPY, which is an established traded currency pair in the interbank spot market. As the dollar's value has eroded during 2008, interest in using the euro as reference currency for prices in commodities (such as oil), as well as a larger component of foreign reserves by banks, has increased dramatically. Transactions in the currencies of commodity-producing countries, such as AUD, NZD, CAD, have also increased.
Determinants of FX rates
The following theories explain the fluctuations in FX rates in a floating exchange rate regime (In a fixed exchange rate regime, FX rates are decided by its government):
(a) International parity conditions: Relative Purchasing Power Parity, interest rate parity, Domestic Fisher effect, International Fisher effect. Though to some extent the above theories provide logical explanation for the fluctuations in exchange rates, yet these theories falter as they are based on challengeable assumptions [e.g., free flow of goods, services and capital] which seldom hold true in the real world.
(b) Balance of payments model (see exchange rate): This model, however, focuses largely on tradable goods and services, ignoring the increasing role of global capital flows. It failed to provide any explanation for continuous appreciation of dollar during 1980s and most part of 1990s in face of soaring US current account deficit.
(c) Asset market model (see exchange rate): views currencies as an important asset class for constructing investment portfolios. Assets prices are influenced mostly by people’s willingness to hold the existing quantities of assets, which in turn depends on their expectations on the future worth of these assets. The asset market model of exchange rate determination states that “the exchange rate between two currencies represents the price that just balances the relative supplies of, and demand for, assets denominated in those currencies.”
None of the models developed so far succeed to explain FX rates levels and volatility in the longer time frames. For shorter time frames (less than a few days) algorithm can be devised to predict prices. Large and small institutions and professional individual traders have made consistent profits from it. It is understood from above models that many macroeconomic factors affect the exchange rates and in the end currency prices are a result of dual forces of demand and supply. The world's currency markets can be viewed as a huge melting pot: in a large and ever-changing mix of current events, supply and demand factors are constantly shifting, and the price of one currency in relation to another shifts accordingly. No other market encompasses (and distills) as much of what is going on in the world at any given time as foreign exchange.
Supply and demand for any given currency, and thus its value, are not influenced by any single element, but rather by several. These elements generally fall into three categories: economic factors, political conditions and market psychology.
Economic factors
These include: (a) economic policy, disseminated by government agencies and central banks, (b) economic conditions, generally revealed through economic reports, and other economic indicators.
• Economic policy comprises government fiscal policy (budget/spending practices) and monetary policy (the means by which a government's central bank influences the supply and "cost" of money, which is reflected by the level of interest rates).
• Government budget deficits or surpluses: The market usually reacts negatively to widening government budget deficits, and positively to narrowing budget deficits. The impact is reflected in the value of a country's currency.
• Balance of trade levels and trends: The trade flow between countries illustrates the demand for goods and services, which in turn indicates demand for a country's currency to conduct trade. Surpluses and deficits in trade of goods and services reflect the competitiveness of a nation's economy. For example, trade deficits may have a negative impact on a nation's currency.
• Inflation levels and trends: Typically a currency will lose value if there is a high level of inflation in the country or if inflation levels are perceived to be rising. This is because inflation erodes purchasing power, thus demand, for that particular currency. However, a currency may sometimes strengthen when inflation rises because of expectations that the central bank will raise short-term interest rates to combat rising inflation.
• Economic growth and health: Reports such as GDP, employment levels, retail sales, capacity utilization and others, detail the levels of a country's economic growth and health. Generally, the more healthy and robust a country's economy, the better its currency will perform, and the more demand for it there will be.
• Productivity of an economy: Increasing productivity in an economy should positively influence the value of its currency. Its effects are more prominent if the increase is in the traded sector.
Political conditions
Internal, regional, and international political conditions and events can have a profound effect on currency markets.
All exchange rates are susceptible to political instability and anticipations about the new ruling party. Political upheaval and instability can have a negative impact on a nation's economy. For example, destabilization of coalition governments in Pakistan and Thailand can negatively affect the value of their currencies. Similarly, in a country experiencing financial difficulties, the rise of a political faction that is perceived to be fiscally responsible can have the opposite effect. Also, events in one country in a region may spur positive/negative interest in a neighboring country and, in the process, affect its currency.
Market psychology
Market psychology and trader perceptions influence the foreign exchange market in a variety of ways:
• Flights to quality: Unsettling international events can lead to a "flight to quality," with investors seeking a "safe haven." There will be a greater demand, thus a higher price, for currencies perceived as stronger over their relatively weaker counterparts. The U.S. dollar, Swiss franc and gold have been traditional safe havens during times of political or economic uncertainty.
• Long-term trends: Currency markets often move in visible long-term trends. Although currencies do not have an annual growing season like physical commodities, business cycles do make themselves felt. Cycle analysis looks at longer-term price trends that may rise from economic or political trends.
• "Buy the rumor, sell the fact": This market truism can apply to many currency situations. It is the tendency for the price of a currency to reflect the impact of a particular action before it occurs and, when the anticipated event comes to pass, react in exactly the opposite direction. This may also be referred to as a market being "oversold" or "overbought". To buy the rumor or sell the fact can also be an example of the cognitive bias known as anchoring, when investors focus too much on the relevance of outside events to currency prices.
• Economic numbers: While economic numbers can certainly reflect economic policy, some reports and numbers take on a talisman-like effect: the number itself becomes important to market psychology and may have an immediate impact on short-term market moves. "What to watch" can change over time. In recent years, for example, money supply, employment, trade balance figures and inflation numbers have all taken turns in the spotlight.
• Technical trading considerations: As in other markets, the accumulated price movements in a currency pair such as EUR/USD can form apparent patterns that traders may attempt to use. Many traders study price charts in order to identify such patterns.
Algorithmic trading in foreign exchange
Electronic trading is growing in the FX market, and algorithmic trading is becoming much more common. According to financial consultancy Celent estimates, by 2008 up to 25% of all trades by volume will be executed using algorithm, up from about 18% in 2005. [Citation needed]
Financial instruments
Spot
A spot transaction is a two-day delivery transaction (except in the case of trades between the US Dollar, Canadian Dollar, Turkish Lira, EURO and Russian Ruble, which settle the next business day), as opposed to the futures contracts, which are usually three months. This trade represents a “direct exchange” between two currencies, has the shortest time frame, involves cash rather than a contract; and interest is not included in the agreed-upon transaction.
Forward
One way to deal with the foreign exchange risk is to engage in a forward transaction. In this transaction, money does not actually change hands until some agreed upon future date. A buyer and seller agree on an exchange rate for any date in the future, and the transaction occurs on that date, regardless of what the market rates are then. The duration of the trade can be one day, a few days, months or years. Usually the date is decided by both parties. Then the forward contract is negotiated and agreed upon by both parties.
Swap
The most common type of forward transaction is the currency swap. In a swap, two parties exchange currencies for a certain length of time and agree to reverse the transaction at a later date. These are not standardized contracts and are not traded through an exchange.
Future
Foreign currency futures are exchange traded forward transactions with standard contract sizes and maturity dates — for example, $1000 for next November at an agreed rate. Futures are standardized and are usually traded on an exchange created for this purpose. The average contract length is roughly 3 months. Futures contracts are usually inclusive of any interest amounts.
Option
A foreign exchange option (commonly shortened to just FX option) is a derivative where the owner has the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date. The FX options market is the deepest, largest and most liquid market for options of any kind in the world..
Speculation
Controversy about currency speculators and their effect on currency devaluations and national economies recurs regularly. Nevertheless, economists including Milton Friedman have argued that speculators ultimately are a stabilizing influence on the market and perform the important function of providing a market for hedgers and transferring risk from those people who don't wish to bear it, to those who do. Other economists such as Joseph Stiglitz consider this argument to be based more on politics and a free market philosophy than on economics.
Large hedge funds and other well capitalized "position traders" are the main professional speculators. According to some economists, individual traders could act as "noise traders" and have a more destabilizing role than larger and better informed actors.
Currency speculation is considered a highly suspect activity in many countries. While investment in traditional financial instruments like bonds or stocks often is considered to contribute positively to economic growth by providing capital, currency speculation does not; according to this view, it is simply gambling that often interferes with economic policy. For example, in 1992, currency speculation forced the Central Bank of Sweden to raise interest rates for a few days to 500% per annum, and later to devalue the krona. Former Malaysian Prime Minister Mahathir Mohamad is one well known proponent of this view. He blamed the devaluation of the Malaysian ringgit in 1997 on George Soros and other speculators.
Gregory J. Millman reports on an opposing view, comparing speculators to "vigilantes" who simply help "enforce" international agreements and anticipate the effects of basic economic "laws" in order to profit.
In this view, countries may develop unsustainable financial bubbles or otherwise mishandle their national economies, and foreign exchange speculators made the inevitable collapse happen sooner. A relatively quick collapse might even be preferable to continued economic mishandling, followed by an eventual, larger, collapse. Mahathir Mohamad and other critics of speculation are viewed as trying to deflect the blame from themselves for having caused the unsustainable economic conditions.
Risk aversion in forex
Risk aversion in the forex is a kind of trading behavior exhibited by the foreign exchange market when a potentially adverse event happens which may affect market conditions. This behavior is caused when risk averse traders liquidate their positions in risky assets and shift the funds to less risky assets due to uncertainty.
In the context of the forex market, traders liquidate their positions in various currencies to take up positions in safe haven currencies, such as the US Dollar. Sometimes, the choice of a safe haven currency is more of a choice based on prevailing sentiments rather than one of economic statistics. An example would be the Financial Crisis of 2008. The value of equities across world fell while the US Dollar strengthened. This happened despite the strong focus of the crisis in the USA.
COMPANY PROFILE
PROFILE OF THE BANK
The Housing Development Finance Corporation Limited (HDFC) was amongst the first to receive an 'in principle' approval from the Reserve Bank of India (RBI) to set up a bank in the private sector, as part of the RBI's liberalization of the Indian Banking Industry in 1994. The bank was incorporated in August 1994 in the name of 'HDFC Bank Limited', with its registered office in Mumbai, India. HDFC Bank commenced operations as a Scheduled Commercial Bank in January 1995.
OVERVIEW OF THE INDUSTRY
HDFC is India's premier housing finance company and enjoys an impeccable track record in India as well as in international markets. Since its inception in 1977, the Corporation has maintained a consistent and healthy growth in its operations to remain the market leader in mortgages. Its outstanding loan portfolio covers well over a million dwelling units. HDFC has developed significant expertise in retail mortgage loans to different market segments and also has a large corporate client base for its housing related credit facilities. With its experience in the financial markets, a strong market reputation, large shareholder base and unique consumer franchise, HDFC was ideally positioned to promote a bank in the Indian environment.
As on 31st December, 2009 the authorized share capital of the Bank is Rs. 550 crore. The paid-up capital as on said date is Rs. 455,23,65,640/- (45,52,36,564 equity shares of Rs. 10/- each). The HDFC Group holds 23.87 % of the Bank's equity and about 16.94 % of the equity is held by the ADS Depository (in respect of the bank's American Depository Shares (ADS) Issue). 27.46 % of the equity is held by Foreign Institutional Investors (FIIs) and the Bank has about 4,58,683 shareholders.
The shares are listed on the Bombay Stock Exchange Limited and The National Stock Exchange of India Limited. The Bank's American Depository Shares (ADS) are listed on the New York Stock Exchange (NYSE) under the symbol 'HDB' and the Bank's Global Depository Receipts (GDRs) are listed on Luxembourg Stock Exchange under ISIN No US40415F2002.
Mr. Jagdish Capoor took over as the bank's Chairman in July 2001. Prior to this, Mr. Capoor was Deputy Governor of the RBI
MANAGEMENT
The Managing Director, Mr. Aditya Puri, has been a professional banker for over 25 years, and before joining HDFC Bank in 1994 was heading Citibank's operations in Malaysia.
The Bank's Board of Directors is composed of eminent individuals with a wealth of experience in public policy, administration, industry and commercial banking. Senior executives representing HDFC are also on the Board.
Senior banking professionals with substantial experience in India and abroad head various businesses and functions and report to the Managing Director. Given the professional expertise of the management team and the overall focus on recruiting and retaining the best talent in the industry, the bank believes that its people are a significant competitive strength.
BOARD OF DIRECTORS
Mr. Jagdish Capoor, Chairman
Mr. Keki Mistry
Mrs. Renu Karnad
Mr. Arvind Pande
Mr. Ashim Samanta
Mr. Chander Mohan Vasudev
Mr. Gautam Divan
Dr. Pandit Palande
Mr. Aditya Puri, Managing Director
Mr. Harish Engineer, Executive Director
Mr. Paresh Sukthankar, Executive Director
Mr. Vineet Jain (upto 27.12.2008)
REGISTERED OFFICE
HDFC Bank House,
Senapati Bapat Marg,
Lower Parel,
Website:
HDFC Bank offers a wide range of commercial and transactional banking services and treasury products to wholesale and retail customers. The bank has three key business segments
Wholesale Banking Services
The Bank's target market ranges from large, blue-chip manufacturing companies in the Indian corporate to small & mid-sized corporates and agri-based businesses. For these customers, the Bank provides a wide range of commercial and transactional banking services, including working capital finance, trade services, transactional services, cash management, etc. The bank is also a leading provider of structured solutions, which combine cash management services with vendor and distributor finance for facilitating superior supply chain management for its corporate customers. Based on its superior product delivery / service levels and strong customer orientation, the Bank has made significant inroads into the banking consortia of a number of leading Indian corporates including multinationals, companies from the domestic business houses and prime public sector companies. It is recognised as a leading provider of cash management and transactional banking solutions to corporate customers, mutual funds, stock exchange members and banks.
Retail Banking Services
The objective of the Retail Bank is to provide its target market customers a full range of financial products and banking services, giving the customer a one-stop window for all his/her banking requirements. The products are backed by world-class service and delivered to customers through the growing branch network, as well as through alternative delivery channels like ATMs, Phone Banking, NetBanking and Mobile Banking.
The HDFC Bank Preferred program for high net worth individuals, the HDFC Bank Plus and the Investment Advisory Services programs have been designed keeping in mind needs of customers who seek distinct financial solutions, information and advice on various
investment avenues. The Bank also has a wide array of retail loan products including Auto Loans, Loans against marketable securities, Personal Loans and Loans for Two-wheelers. It is also a leading provider of Depository Participant (DP) services for retail customers, providing customers the facility to hold their investments in electronic form.
HDFC Bank was the first bank in India to launch an International Debit Card in association with VISA (VISA Electron) and issues the Mastercard Maestro debit card as well. The Bank launched its credit card business in late 2001. By March 2009, the bank had a total card base (debit and credit cards) of over 13 million. The Bank is also one of the leading players in the “merchant acquiring” business with over 70,000 Point-of-sale (POS) terminals for debit / credit cards acceptance at merchant establishments. The Bank is well positioned as a leader in various net based B2C opportunities including a wide range of internet banking services for Fixed Deposits, Loans, Bill Payments, etc.
Treasury
Within this business, the bank has three main product areas - Foreign Exchange and Derivatives, Local Currency Money Market & Debt Securities, and Equities. With the liberalisation of the financial markets in India, corporates need more sophisticated risk management information, advice and product structures. These and fine pricing on various treasury products are provided through the bank's Treasury team. To comply with statutory reserve requirements, the bank is required to hold 25% of its deposits in government securities. The Treasury business is responsible for managing the returns and market risk on this investment portfolio
Awards and Achievements - Banking Services
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Corporate Governance:
The bank was among the first four companies, which subjected itself to a Corporate Governance and Value Creation (GVC) rating by the rating agency, The Credit Rating Information Services of India Limited (CRISIL).
The rating provides an independent assessment of an entity's current performance and an expectation on its "balanced value creation and corporate governance practices" in future. The bank has been assigned a 'CRISIL GVC Level 1' rating, which indicates that the bank's capability with respect to wealth creation for all its stakeholders while adopting sound corporate governance practices is the highest.
We are aware that all these awards are mere milestones in the continuing, never-ending journey of providing excellent service to our customers. We are confident, however, that with your feedback and support, we will be able to maintain and improve our services.
Technology:
HDFC Bank operates in a highly automated environment in terms of information technology and communication systems. All the bank's branches have online connectivity, which enables the bank to offer speedy funds transfer facilities to its customers. Multi-branch access is also provided to retail customers through the branch network and Automated Teller Machines (ATMs).
The Bank has made substantial efforts and investments in acquiring the best technology available internationally, to build the infrastructure for a world class bank. The Bank's business is supported by scalable and robust systems which ensure that our clients always get the finest services we offer. The Bank has prioritized its engagement in technology and the internet as one of its key goals and has already made significant progress in web-enabling its core businesses. In each of its businesses, the Bank has succeeded in leveraging its market position, expertise and technology to create a competitive advantage and build market share.
Mission and Business Strategy:
Our mission is to be "a World Class Indian Bank", benchmarking ourselves against international standards and best practices in terms of product offerings, technology, service levels, risk management and audit & compliance. The objective is to build sound customer franchises across distinct businesses so as to be a preferred provider of banking services for target retail and wholesale customer segments, and to achieve a healthy growth in profitability, consistent with the Bank's risk appetite. We are committed to do this while ensuring the highest levels of ethical standards, professional integrity, corporate governance and regulatory compliance.
HDFC’s business strategy emphasizes the following:
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HDFC Bank is headquartered in Mumbai. The Bank at present has an enviable network of 1,725 branches spread in 771 cities across India. All branches are linked on an online real-time basis. Customers in over 500 locations are also serviced through Telephone Banking. The Bank's expansion plans take into account the need to have a presence in all major industrial and commercial centres where its corporate customers are located as well as the need to build a strong retail customer base for both deposits and loan products. Being a clearing/settlement bank to various leading stock exchanges, the Bank has branches in the centres where the NSE/BSE have a strong and active member base.
The Bank also has 3,898 networked ATMs across these cities. Moreover, HDFC Bank's ATM network can be accessed by all domestic and international Visa/MasterCard, Visa Electron/Maestro, Plus/Cirrus and American Express Credit/Charge cardholders.
AIMS:
➢ Continuous effort to improving the services.
➢ Evaluating individual skill trough training and motivations.
➢ Total involvement through participant’s management activities.
➢ Creating healthy and safe environment.
➢ Social development.
Credit Rating
The Bank has its deposit programs rated by two rating agencies - Credit Analysis & Research Limited (CARE) and Fitch Ratings India Private Limited. The Bank's Fixed Deposit programmed has been rated 'CARE AAA (FD)' [Triple A] by CARE, which represents instruments considered to be "of the best quality, carrying negligible investment risk." CARE has also rated the bank's Certificate of Deposit (CD) programmed "PR 1+" which represents "superior capacity for repayment of short term promissory obligations". Fitch Ratings India Pvt. Ltd. (100% subsidiary of Fitch Inc.) has assigned the "AAA (ind)" rating to the Bank's deposit programmed, with the outlook on the rating as "stable". This rating indicates "highest credit quality" where "protection factors are very high".
Corporate Governance Ratin
The bank was one of the first four companies, which subjected itself to a Corporate Governance and Value Creation (GVC) rating by the rating agency, The Credit Rating Information Services of India Limited (CRISIL). The rating provides an independent assessment of an entity's current performance and an expectation on its "balanced value creation and corporate governance practices" in future. The bank was assigned a 'CRISIL GVC Level 1' rating in January 2007 which indicates that the bank's capability with respect to wealth creation for all its stakeholders while adopting sound corporate governance practices is the highest.
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|Products |
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|[pic] Forex Buy and Sell |
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|[pic] Travel Card |
|[pic]Traveler’s Cheques |
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|[pic] Western Union |
|RBI Guide Lines |
|* this is only a brief extract and for details kindly refer to the RBI website – .in |
|Authorized Dealer Category-II Money Changers can undertake |
|Purchase – from Residents / Non- Residents |
|Sales to Residents for Private Travel and Business Travel. |
|AD-Category II can undertake specified Non- Trade Current A/C |
|Transactions in addition to the above. |
|For limits and conditions – kindly refer to the table under "Forex Limits" |
|Bringing in and taking out of Foreign Exchange |
|Foreign Exchange can be brought into India without limit; |
|Declaration in form CDF necessary if the Amount > USD 10,000 (FC notes + TCs) and / or FC notes exceed USD 5000; |
|Taking out Foreign Exchange other than that obtained from AD/AMC prohibited; |
|Non- residents can take out Foreign Exchange up to the amount originally brought in; |
|Purchases of Foreign Currency from Public /Foreign Nationals: |
|Purchase from Residents / Non – Residents/foreign nationals FC Notes/ Coins/ TC's subject to submission of CDF (wherever applicable) to be taken; |
|Facility to avail INR against International Credit Cards by foreign tourists |
|Encashment Certificate to be issued in all cases of Encashments; |
|No limit for encashment is prescribed, if declared on the Currency Declaration Form (CDF) on arrival to the customs authorities. |
|No declaration in CDF is required for Foreign Currency with aggregate value upto US 5000 or equivalent; |
|No declaration in CDF is required for FC + TC with aggregate value upto US 10000 or equivalent; |
|For purchase of foreign currency notes and/ or Travellers' Cheques from customers for any amount less than Rs. 50,000/-, or its equivalent, copies of identification|
|documents not required. However, details of the identification document to be furnished by the customer/ to be kept on record by the AMC; |
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|For purchase of foreign currency notes and/ or Travellers' Cheques from customers for any amount equal to or in excess of Rs.50,000/-, or its equivalent, documents,|
|as mentioned at (F-Part-II) annexed to the A.P. (DIR Series) Circular No.17 {A.P.(FL/RL Series) Circular No.4} dated November 27, 2009, should be verified and |
|copies retained. |
|Permissible limit for cash payments against encashment: |
|a) Foreign Nationals up to -- US $ 3000 |
|b) Residents up to -- US $ 1000 |
|All other cases of encashments, payment to be made by way of Account Payee Cheque or demand draft only. |
|Payment to be made only by Cheque / DD, if purchases are from other FFMC/AD's; |
|Sale of foreign exchange Private Visits / Business Visits: |
|Sale against application, identification documents and declaration regarding Foreign Exchange availed during the financial year; |
|Private visit- up to USD 10,000 per financial year. |
|.Business visit-up to USD 25,000 per trip for Business / Conference / Training etc. |
|TC issue subject to conditions of TC issuing company; |
|Traveler to sign on the TC in the presence of Authorized official of AMC; |
|Payment in excess of Rs.50, 000 to be received by Cheque / DD; |
|Foreign Currency Notes up to USD 3000 and balance in TC's/Travel cards; |
|Exemptions - Travelers visiting |
|Libya & Iraq up to US $ 5000 |
|Islamic Republic of Iran, Russian Federation and commonwealth of Independence States – Entire exchange to be released in FC notes; |
|6. Sales against Reconversion of Indian Currency |
|Non-residents are allowed to reconvert unspent INR at the time of their departure subject to production of a valid Encashment Certificate. |
|Non-residents are allowed to reconvert INR up to Rs.10,000 without a valid Encashment Certificate, for bonafide reasons, if departure is scheduled to take place |
|within the following seven days. |
|Facility for reconversion of Indian Rupees to the extent of Rs. 50,000/- to foreign tourists (not NRIs) against ATM Receipts, are allowed subject to submission of |
|the following documents: |
|Valid Passport and VISA |
|Ticket confirmed for departure within 7 days. |
|Original ATM slip (to be verified with the original debit/ credit card). |
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|CHAPTER-III |
|REVIEW OF LITERATURE |
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|INTRODUCTION TO FOREIGN EXCHNGE |
|AND |
|ITS ADMINISTRATIVE FRAME WORK |
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|Definition of International Trade: |
|International trade refers to trade between the residents of two different countries. Each country functions as a sovereign state with its own set of regulations |
|and currency. The difference in the nationality of the export and the importer presents certain peculiar problem in the conduct of international trade and |
|settlement of the transactions arising there from. |
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|Important among such problems are: |
|Different countries have different monetary units; |
|Restrictions imposed by counties on import and export of goods: |
|Restrictions imposed by nations on payments from and into their countries; |
|Different in legal practices in different countries. |
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|The existing of national monetary units poses a problem in the settlement of international transactions. The exporter would like to get the payment in the currency |
|of own country. For instance, if American exporter of New York export machinery to Indian rupee will not serve their purpose because Indian rupee cannot be used as |
|currency inn rupees. Thus the exporter requires payment in the importer’s country. A need, therefore, arises for conversion of the currency of the importer’s |
|country into that of the exporters country. |
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|Foreign exchange: Foreign exchange is the mechanism by which the currency of one country gets converted into the currency of another country. The conversion is done|
|by banks who deal in foreign exchange. These banks maintain stocks of foreign currencies in the form of balances with banks abroad. For instance, Indian Bank may |
|maintain an account with Bank of America, new York, in which dollar are held. In the earlier example, if Indian importers pay the equivalent rupee to Indian bank, |
|it would arrange to pay American export at New York in dolor from the dollar balances held by it with Bank of America. |
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|Exchange rate: |
|The rate at which one currency is converted into another currency is the rate of exchange between the currencies concerned. The rate of exchange for a currency is |
|known from the quotation in the foreign exchange market. |
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|In the illustration, if Indian bank exchanged us for Indian rupee at Rs.45.10 a dollar, the exchange rate between rupee and dollar can be expressed as |
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|USD 1=Rs.45.10. |
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|The banks operating at a financial center, and dealing in foreign exchange, constitute the foreign exchange market. As in any commodity or market, the rates in the |
|foreign exchange market are determined by the interaction of the forces of demand and supply of the commodity dealt, viz., foreign exchange. Since the demand and |
|supply are affected by a number of factors, both fundamental and transitory, the rates keep on changing frequently, and violently too. |
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|Some of the important factors which affect exchange rates are: |
|Balance of payments |
|Inflation |
|Interest rates |
|Money Supply |
|National Income |
|Resource Discoveries |
|Capital Movements |
|Political Factors |
|Psychological Factors and Speculation |
|Technical and Market Factors |
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|Balance of payment: It represents the demand for and supply of foreign exchange which ultimately determine the value of the currency. Exporters from the country |
|demand for the currency of the country in the forex market. The exporters would offer to the market the foreign currencies have acquired and demand in exchange the |
|local currency. Conversely, imports into the country will increase the supply of currency of the country in the forex market. When the BOP of a country is |
|continuously at deficit, it implies that demand for the currency of the country is lesser than the supply. Therefore, its value in the market declines. If the BPO |
|is surplus, continuously, it shows the demand for the currency is higher than its supply and therefore the currency gains in value. |
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|Inflation: inflation in the country would increase the domestic prices of the commodities. With increase in prizes exports may dwindle because the price may not be |
|competitive. With the decrease in export the demand for the currency would also decline; this it in turn would result in the decline of external value of the |
|currency. It should be noted that it is the relative rate of inflation in the two counties that cause changes in the exchange rates. |
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|Interest rates: The interest rate has a great influence on the short-term movement of capital. When the interest rate at a center rises, it attracts short term |
|funds from other centers. This would increase the demand for the currency at the center and hence its value. Rising of interest rate may be adopted by a country due|
|to money conditions or as a deliberate attempt to attract foreign investment. |
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|Money supply: An increase in money supply in the country will affect the exchange rates through causing inflation in the country. It can also affect the exchange |
|rate directly. |
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|National income: An increase in national income reflects increase in the income of the residents of the country. The increase in the income increases the demand for|
|goods in the country. If there is underutilized production capacity in the country, this would lead to increase in production. There is a change for growth in |
|exports too. Where the production does not increase in sympathy with income rises, it leads to increased imports and increased supply of the currency of the country|
|in the foreign exchange market. The result is similar to that of inflation viz., and decline in the value of the currency. Thus an increase in national income will |
|lead to an increase in investment or in the consumption, and accordingly, its effect on the exchange rate will change. |
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|Resource discoveries: When the country is able to discover key resources, its currency gains in value. |
|Capital Movements: There are many factors that influence movement of capital from one country to another. Short term movement of capital may be influenced by the |
|offer of higher interest in a country. If interest rate in a country rises due to increase in bank rate or otherwise, there will be a flow of short-term funds into |
|the country and the exchange rate of the country will rise. Reserves will happen in case of fall in interest rates. |
|Bright investment climate and political stability may encourage portfolio investment in the country. This leads to higher demand for the currency and upward trend |
|in its rate. Poor economic outlook may mean repatriation of the investments leading to decreased demand and lower exchange value for the currency of the country. |
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|Movement of capital is also caused by external borrowings and assistance. Large-scale external borrowings will increase the supply of foreign exchange in the |
|market. This will have a favorable effect on the exchange rate of the currency of the country. When a repatriation of principal and interest starts the rata may be |
|adversely affected. |
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|Other factors include political factors, Psychological factors and Speculation, Technical and Market factors. |
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|ADMINISTRATION FRAME WORK FOR FOREIGN EXCHANGE IN INDIA |
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|The Central Government has been empowered under Section 46 of the Foreign Exchange Management Act to make rules to carry out the provisions of the Act. Similarly, |
|Section 47 empowers the Reserve Bank to make regulations to carry out the provisions of the Act and the rules made there under. |
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|The Foreign Contribution (Regulation) Act, 1976 is to regulate the acceptance and utilization of foreign contribution/ donation or foreign hospitality by certain |
|persons or associations , with a view to ensuring that Parliamentary institutions, political associations and academic and other voluntary organizations as well as |
|individuals working in the important areas of national life may function in a manner consistent with the values of a sovereign democratic republic. |
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|It is basically an act to ensure that the integrity of Indian institutions and persons is maintained and that they are not unduly influenced by foreign donations to|
|the prejudice of India’s interests. |
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|The Foreign Exchange Management Act (FEMA) is a law to replace the draconian Foreign Exchange Regulation Act, 1973. Any offense under FERA was a criminal offense |
|liable to imprisonment, Whereas FEMA seeks to make offenses relating to foreign exchange civil offenses. Unlike other laws where everything is permitted unless |
|specifically prohibited, under FERA nothing was permitted unless specifically permitted. Hence the tenor and tone of the Act was very drastic. It provided for |
|imprisonment of even a very minor offense. Under FERA, a person is presumed innocent unless he is proven guilty. With liberalization, a need was felt to remove the |
|drastic measure of FERA and replace them by a set of liberal foreign exchange management regulations. Therefore FEMA was enacted to replace FERA. |
|FEMA extends to the whole of India. It applies to all Branches, offences and agencies outside India owned or controlled by a person resident in India and also to |
|any contravention there under committed outside India by any person to whom this Act applies. |
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|FEMA contains definitions of certain terms which have been used throughout the Act. The meaning of these terms may differ under other laws or common language. But |
|for the purpose of FEMA, the terms will signify the meaning as defined there under. |
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|Authorized persons: |
|With the Reserve Bank has the authority to administer foreign exchange in India, it is recognized that it cannot do so by itself. Foreign exchange is received or |
|required by a large number of exports and imports in the country spread over a vast geographical area. It would be impossible for the reserve Bank to deal with them|
|individually. Therefore, provisions has been made in the Act, enabling the Reserve Bank to authority any person to be known as authority person to deal in the |
|foreign exchange or foreign securities, as an authorized dealer, money changer or off- shore banking unit or any other manner as it deems fit. |
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|Authorized dealers: |
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|A major portion of actual dealing in foreign exchange from the customers (importers, exporters and others receiving or making personal remittance) is dealt with by |
|such of the banks in India which have been authorized by Reserve |
|Bank to deal in foreign exchange. Such of the banks and selected financial institutions who have been authorized Dealer. |
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|Fig: ADMINISTRATION OF FOREIGN EXCHANGE IN INDIA |
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|FOREIGN EXCHANGE DEALER’S ASSOCIATION OF |
|INDIA (FEDAI) |
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|FEDAI was establishing in 1958 as an association of all authorized dealers in India. The principal functions of FEDAI are: |
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|To frame rules for the conduct of foreign exchange business in India. These rules cover various aspects like hours of business, charges for foreign exchange |
|transactions, quotation of rates to customer, inter bank dealings, etc. All authorized dealers have given undertaking to the Reserve Bank to abide these rules. |
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|To coordinate with Reserve Bank of India in Proper administration of exchange control. |
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|To control information likely to be of interest to its members. |
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|Thus, FEDAI provides a vital link in the administrative set-up of foreign exchange in India. |
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|AUTHORIZED MONEY CHANGERS |
|To provide facilities for encashment of foreign currency for tourists, etc., Reserve Bank has granted limited licenses to certain established firms, hotels and |
|other organizations permitting them to deal in foreign currency notes, coins and travelers’ cheques subject to directions issued to them from time to time. These |
|firms and organizations are called ‘Authorized Money Changers’. An authorized money changer may be a full fledged money changer or a restricted money changer. A |
|full fledged money changer is authorized to undertake both purchase and sale transactions with the public. A restricted money changer is authorized only to purchase|
|foreign currency notes, coins and travelers’ cheques subject to the condition that all such collections are surrendered by him in turn to authorized dealer in |
|foreign exchange. The current thinking of the Reserve Bank is to authorize more establishments as authorized money changers in order to facilitate easy conversion |
|facilities. |
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|THE FOREIGN EXCHANGE MARKET |
|The Foreign exchange market is the market where in which currencies are bought and sold against each other. It is the largest market in the world. It is to be |
|distinguished from a financial market where currencies are borrowed and lent. |
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|Foreign exchange market facilitate the conversion of one currency to another for various purposes like trade, payment for services, development projects, |
|speculation etc. Since the number of participants in the market s has increased over the years have become highly competitive and efficient. |
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|With improvement in trade between countries, there was a pressing need to have some mechanism to facilitate easy conversion of currencies. This has been made |
|possible by the foreign exchange markets. |
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|Considering international trade, a country would prefer to import goods for which it does not have a competitive advantage, while exporting goods for which it has a|
|competitive advantage over others. |
|Thus trade between countries is important for common good but nations are separated by distance, which that there is a lot of time between placing an order and its |
|actual delivery. No supplier would be willing to wait until actual delivery for receiving payments. Hence, credit is very important at every stage of the |
|transaction. The much needed credit servicing and conversion of the currency is facilitated by the foreign exchange market. |
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|Also the exchange rates are subject to wide fluctuations. There is therefore, a constant risk associated exchange markets cover the arising out of the fluctuations |
|in exchange rates through “hedging”. |
|Forex market is not exactly a place and that there is no physical meeting but meeting is affected by mail or over phone. |
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|FOREIGN EXHANGE TRANSACTIONS |
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|Foreign exchange transactions taking place in foreign exchange markets can be broadly classified into Inter bank transactions and Merchant transactions. The foreign|
|exchange transactions taking place among banks are known as inter bank transactions and the rates quoted are known as inter bank rates. The foreign exchange |
|transactions that take place between a bank and its customer known as’ Merchant transactions’ and the rates quoted are known as merchant rates. |
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|Merchant transactions take place when as exporter approaches his bank to convert his sale proceeds to home currency or when an importer approaches his banker to |
|convert domestic currency into foreign currency to pay his dues on import or when a resident approaches his bank to convert foreign currency received by him into |
|home currency or vice versa. When a bank buys foreign exchange from a customer it sells the same in the inter bank market at a higher rate and books profit. |
|Similarly, when a bank sells foreign exchange to a customer, it buys from the inter bank market, loads its margin and thus makes a profit in the deal. |
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|The modes of foreign exchange remittances |
|Foreign exchange transactions involve flow of foreign exchange into the country or out of the country depending upon the nature of transactions. A purchase |
|transaction results in inflow of foreign exchange while a sale transaction result in inflow of foreign exchange. The former is known as inward remittance and the |
|latter is known as outward remittance. |
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|Remittance could take place through various modes. Some of them are: |
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|Demand draft |
|Mail transfer |
|Telegraphic transfer |
|Personal cheques |
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|Types of buying rates: |
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|TT buying rate and |
|Bill buying rate |
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|TT buying rate is the rate applied when the transaction does not involve any delay in the realization of the foreign exchange by the bank. In other words, the |
|Nastro account of the bank would already have been credited. This rate is calculated by deducting from the inter bank buying rate the exchange margin as determined |
|by the bank. |
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|Bill buying rate: |
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|This is the rate to be applied when foreign bill is purchased. When a bill is purchased, the rupee equivalent of the bill values is paid to the exporter |
|immediately. |
|However, the proceeds will be realized by the bank after the bill is presented at the overseas centre. |
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|Types of selling rates: |
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|TT selling rates |
|Bill selling rates |
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|TT Selling rate: |
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|All sale transactions which do not handling documents are put through at TT selling rates. |
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|Bill Selling rates: This is the rate applied for all sale transactions with public which involve handling of documents by the bank. |
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|Inter Bank transactions: |
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|The exchange rates quoted by banks to their customer are based on the rates prevalent in the Inter Bank market. The big banks in the market are known as market |
|makers, as they are willing to pay or sell foreign currencies at the rates quoted by them up to any extent. Depending upon its resources, a bank may be a market in |
|one or few major currencies. When a banker approaches the market maker, it would not reveal its intention to buy or sell the currency. This is done in order to get |
|a fair price from the market maker. |
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|Two way quotations |
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|Typically, then quotation in the Inter Bank market is a two- way quotation. It means, the rate quoted by the market maker will indicate two prices, one which it is |
|willing to buy the foreign currency and the other at which it is willing to sell the foreign currency. For example, a Mumbai bank may quote its rate for US dollars |
|as under. |
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|USD 1= Rs.45.15255/1650 |
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|More often, the rate would be quoted as 1525/1650 since the players in the market are expected to know the ‘big number’ i.e., Rs.41. in the above quotation, once |
|rate us Rs.45.1525 per dollar and the other rate is Rs.45.1650 per dollar. |
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|Direct quotation |
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|It will be obvious that the quotation bank will be to buy dollars at 45.1525 and sell dollars at Rs45.1650. if once dollar bought and sold, the bank makes a profit |
|of 0.0125. |
|In a foreign exchange quotation, the foreign currency is the commodity that is being bought and sold. The exchange quotation which gives the price for the foreign |
|v\currency in term of the domestic currency is known as direct quotation. In a direct quotation, the quoting bank will apply the rule: “buy low’ sell high”. |
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|Indirect quotation |
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|There is another way of quoting in the foreign exchange market. The Mumbai bank quote the rate for dollar as: |
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|Rs.100=USD 2.2162/4767 |
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|This type of quotation which gives the quality of foreign currency per unit of domestic currency is known as indirect quotation. In this case, the quoting bank will|
|receive USD 2.2167 per Rs.100 while buying dollars and give away USD 2.2162 per Rs.100 while selling dollars In other words, “Buy high, sell low” is applied. |
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|This buying rate is also known as the ‘bid’ rate and the selling rate as the ‘offer’ rate. The difference between these rates is the gross profit for the bank and |
|known as the ‘Spread’. |
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|Spot and forward transactions |
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|The transactions in the Inter Bank market May place for settlement- |
|On the same day; or |
|Two days later; |
|Some day late; say after a month |
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|Where the agreement to buy and sell is agreed upon and executed on the same date, the transaction is known as cash or ready transaction. It is also known as value |
|today. |
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|The transaction where the exchange of currencies takes place after the date of contract is known as the Spot Transaction. For instance if the contract is made on |
|Monday, the delivery should take place on Wednesday. If Wednesday is a holiday, the delivery will take place on the next day, i.e., Thursday. Rupee payment is also |
|made on the same day the foreign exchange is received. |
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|The transaction in which the exchange of currencies takes place at a specified future date, subsequent to the spot rate, is known as a forward wtransaction. The |
|forwards transaction can be for delivery one month or two months or three months, etc. A forward contract for delivery one month means the exchange of currencies |
|will take place after one month from the date of contract. A forwards contract for delivery two months means the exchange of currencies will take place after two |
|months and so on. |
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|Spot and Forwards rates |
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|Spot rate of exchange is the rate for immediate delivery of foreign exchange. It is prevailing at a particular point of time. In a forward rate, the quoted is for |
|delivery at a future date, which is usually 30, 60, 90 or 180 days later. The forward rate may be at premium or discount to the spot rate, Premium rate, i.e., |
|forward rate is higher than the spot rate, implies that the foreign currency is to appreciate its value in tae future. May be due to larger demand for goods and |
|services of the country of that currency. The percentage of annualized discount or premium in a forward quote, in relation to the spot rate, is computed by the |
|following. |
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|Forward Premium = Forward rate-spot rate * 12 |
|(discount ) Spot rate No. of months forward |
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|If the spot rate is higher than the forward rate, there is forward discount and if the forward rate higher than the spot rate there is forward premium rate. |
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|Forward margin/Swap points |
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|Forward rate may be the same as the spot rate for the currency. Then it is said to be ‘at par’ with the spot rate. But this rarely happens. More often the forward |
|rate for a currency may be costlier or cheaper than its spot rate. The difference between the forward rate and the spot rate is known as the ‘Forward margin’ or |
|‘Swap Points’. The forward margin may be at a premium or at discount. If the forward margin is at premium, the foreign currency will be costlier under forward rate |
|than under the spot rate. If the forward margin is at discount, the foreign currency will be cheaper for forward delivery than for spot delivery. |
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|Under direct quotation, premium is added to the spot rate to arrive at the forward rate. This is done for both purchase and sale transactions. Discount is deducted |
|from spot rate to arrive at the forward rates. |
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|Other rates |
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|Buying rate and selling refers to the rate at which a dealer in forex is willing to buy the forex and sell the forex. In theory, there should not be difference in |
|these rates. But in practices, the selling rate is higher than the buying rate. The forex dealer, while buying the forex pay less rupees, but gets more when he |
|sells the forex. After adjusting for operating expenses, the dealer books a profit through the ‘buy and sell’ rates differences. |
|Transactions in exchange market consist of purchases and sales of currencies between dealers and customers and between dealers and dealers. The dealers buy forex in|
|the form of bills, drafts and with foreign banks, from customer to enable them to receive payments from abroad. |
|The resulting accumulated currency balances with dealers are disposed of by selling instruments to customers who need forex to make payment to foreigners. The |
|selling price for a currency quoted by the dealer (a bank) is slightly higher than the purchase price to give the bank small profit in the business. Each dealer |
|gives a two-way quote in forex. |
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|Single Rate refers to the practices of adopting just rate between the two currencies. A rate for exports, other for imports, other for transaction with preferred |
|area, etc, if adopted by a country, that situation is known as multiple rates. |
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|Fixed rate refers to that rate which is fixed in terms of gold or is pegged to another currency which has a fixed value in terms of gold. Flexible rate keeps the |
|exchange rate fixed over a short period, but allows the same to vary in the long term in view of the changes and shifts in another as conditioned by the free of |
|market forces. The rate is allowed to freely float at all times. |
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|Current rate: |
|Current rate of exchange between two currencies fluctuate from day to day or even minute to minute, due to changes in demand and supply. But these movements take |
|place around a rate |
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|which may be called the ‘normal rate’ or the par of exchange or the true rate. International payments are made by different instruments, which differ in their time |
|to maturity. |
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|A Telegraphic Transfer (TT) is the quickest means of effecting payments. A T.T rate is therefore, higher than that of any other kind of bill. A sum can be |
|transferred from a bank in one country to a bank in another part of the world by cable or telex. It is thus, the quickest method of transmitting funds from one |
|center to another. |
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|Slight rates applicable in the case of bill instrument with attending delay in maturity and possible loss of instrument in transit, are lower than most other rates.|
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|Similarly, there are other clusters of rates, such as, one month’s rate, 3month’s rate. Longer the duration, lower the price (of the foreign currency in terms of |
|domestic). |
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|The exchange rate between two given currencies may be obtained from the rates of these two currencies in terms of a third currency. The resulting rate is called the|
|Cross rate. |
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|Arbitrage in the foreign exchange market refers to buying a foreign currency in a market where it is selling lower and selling the same in a market where it is |
|bought higher. Arbitrage involves no risk as rates are known in advance. Further, there is no investment required, as the purchase of one currency is financed by |
|the sale of other currency. Arbitrageurs gain in the process of arbitraging. |
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|INTRODUCTION TO THE FOREIGN EXCHANGE RISK MANAGEMENT |
|Risk: |
|Risk is the possibility that the actual result from an action will deviate from the expected levels of result. The greater the magnitude of deviation and greater |
|the probability of its occurrence, the greater is the risk. |
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|A business has to take step to minimize the risk by adopting appropriate technique or policies. Risk management focuses on identifying and implementing these |
|technique or policies, lest the business should be left exposed to uncertain outcomes. |
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|Risk management: |
|Risk management is a process to identify loss exposure faced by an organization and to select the most appropriate technique such exposures. |
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|Risk management tools measure potential loss and potential gain. It enables us to stay with varying degree of certainty and confidence levels, that our potential |
|loss will not exceed a certain amount if we adopt a particular strategy. Risk management enables us to confront uncertainty head on, acknowledge its existence, try |
|to measure its extent and finally control it. |
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|Risk management makes sense for two reasons. One, a business entity generally wishes to reduce risks to acceptable levels. Two, a business entity is generally keen |
|on avoiding particularly kind of risks, for it may be too great for the business to bear. For each situation where one wishes to avoid a risk- a loss by fire, for |
|example- three is, perhaps, a counter party who may be willing such risk. For risk reduction, a business entity can adopt the following methods. |
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|Hedging: |
|Hedging is a technique that enables one party to minimize the effect of adverse outcomes, in a given situation. Parties come together to minimize the effect of |
|which risk of one party gets cancelled by the risk of another. IT is not that risk minimization is the only strategy. An entity may even choose to remain exposed, |
|in anticipation of reaping profits from its risk taking positions. |
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|FOREIGN EXCHANGE EXPOSURE |
|Exposure: |
|Exposure is defined as the possibility of a change in the assets or liabilities or both of a company as a result in the exchange rate. Foreign exchange exposure |
|thus refers to the possibility of loss or gain to a company that arises due to exchange rate fluctuations. |
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|The value of a firm’s assets, liabilities and operating income vary continually in response to changes in a myriad economic and financial variable such as exchange |
|rates, interest rates, inflation rates, relative price and so forth. We can these uncertainties as macroeconomic environment risks. These risks affect all firms in |
|the economy. However, the extent and nature of impact of even macroeconomic risks crucially depend upon the nature of firm’s business. For instance, fluctuations of|
|exchange rate will |
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|affect net importers and exporters quite differently. The impact of interest rate fluctuations will be very different from that on a manufacturing firm. |
|The nature of macroeconomic uncertainty can be illustrated by a number of commonly encountered situations. An appreciation of value of a foreign currency(or |
|equivalently, a depreciation of the domestic currency), increase the domestic currency value of a firm’s assets and liabilities denominated in the foreign |
|currency-foreign currency receivables and payables, banks deposits and loans, etc. It ill also change domestic currency cash flows from exports and imports. An |
|increase in interest rates reduces the market value of a portfolio of fixed-rate in the rate of inflation may increase value of unsold stocks, the revenue from |
|future sales as well as the future costs of production. Thus the firms exposed to uncertain changes in a numbers of variable in its environment. These variables |
|are sometimes called Risk Factors. |
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|The nature of Exposure and Risk |
|Exposure are a measure of the sensitivity of the value of a financial items (assets, liabilities or cash flow) to changes in the relevant risk factor while risk is |
|a measurable of the variability of the item attributable to the risk factor. |
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|Corporate treasurers have become increasingly concerned about exchange rate and interest rate exposure and risk during the last ten to fifteen years or so. In the |
|case of exchange rate risk, The increased awareness is firstly due to tremendous increase in the volume of cross border financial transactions (which create |
|exposure) and secondly due to the significant increase in the degree of volatility in exchange rates(which, given the exposure, creates risk) |
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|Classification of foreign exchange exposure and risk |
|Since the advent of floating exchange rates in 1973, firms around the world have become acutely aware of the fact that fluctuations in exchange rates expose their |
|revenues, costs, operating cash flows and thence their market value to substantial fluctuations. Firms which have cross-border transactions-exports and imports of |
|goods and services, foreign borrowings and lending, foreign portfolio and direst investment etc, are directly exposed: but even purely domestic firms which have |
|absolutely no cross border transactions are also exposed because their customers, suppliers and competition are exposed. Considerably effort has since been devoted |
|to identifying and categorizing currency exposure and developing more and more sophisticated methods to quantify it. |
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|Foreign exchange exposure can be classified into three broad categories: |
|Transaction exposure |
|Translation exposure |
|Operating exposure |
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|Of these, the first and third together are sometimes called “Cash Flow Exposure” while the second is referred to as “Accounting Exposure” or Balance sheet |
|Exposure”. |
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|Transaction exposure |
|When a firm has a payable or receivable denominated in a foreign currency, a change in the exchange rate will alter the amount of local currency receivable or paid.|
|Such a risk or exposure is referred to as transaction exposure. |
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|For example , if an Indian exporter has a receivable of $100,100 due three months hence and if in the meanwhile the dollar depreciates relative to the rupee a cash |
|loss occurs. Conversely, if the dollar appreciates relative to the rupee, a cash gain occurs. In the case of payable, the outcome is of an opposite kind: a |
|depreciation of the dollar relative to the rupee results in a gain, where as an appreciation of the dollar relative to the rupee result in a loss. |
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|Translation exposure |
|Many multinational companies require that their accounts of foreign subsidiaries and branches get consolidated with those of it. For such consolidation, assets and |
|liabilities expressed in foreign currencies have to be translated into domestic currencies at the exchange rate prevailing on the consolidation dates. If the values|
|of foreign currencies change between a two or successive consolidation dates, translation exposure will arise. |
|Operating exposure |
|Operating exposure, like translation exposure involve an actual or potential gain or loss. While the former is specific to the transaction, the latter relates to |
|entire investment. The essence of this operating exposure is that exchange rate changes significantly and alter the cost of firm’s inputs along with price of it |
|output and thereby influence its competitive position substantially. |
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|Eg: Volkwagon had ahighly successful export market for its ‘beetle’ model in the US before 1970. With the breakdown of Bretten-woods of fixes exchanged rates, the |
|deuschemark appreciated significantly against the dollar. This created problem for Volkswagan as its expenses were mainly in deuschemark but its revenue in dollars.|
|However, in a highly price-sensitive US market, such an action caused a sharp decreased in sales volume-from 600,000 vehicles in 1968 to 200,000 in |
|1976.(Incidentally, Volkswagen’s 1973 losses were the highest, as of that year, suffered by any company anywhere in the world.) |
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|TOOLS AND TECHNIQUES FOR THE MANAGEMENT OF FOREIGN EXCHANGE RISK |
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|Hedging exposures, sometimes called risk management, is widely resorted to by financial directors, corporate treasurers and portfolio managers. |
|The practice of covering exposure is designed to reduce the volatility of a firm’s profits and/or cash management and it presumably follows that this will reduce |
|the volatility of the value of the firm. |
|There are a wide range of methods available to minimize foreign exchange risk which are classified as internal and external techniques of exposure management. |
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|Internal techniques |
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|Internal techniques of exposure management help to resolve exposure risks through regulating the firms financial position. Thereby, they ensure that the firm is not|
|endangered through exposures. The fundamental stress minimizing of not complete elimination of exchange losses that are likely to accrue as a result of exposure. |
|They use methods of exposure management which are a part of a firm’s regulatory financial management and do not resort to special contractual relationship outside |
|the group of companies concerned. They aim at reducing exposed position or preventing them from arising. They embrace netting, matching, leading and lagging, |
|pricing policies and asst/liability management. |
|Internal techniques of exposure management do not rely on 3rd party contracts to manage exposed positions. Rather, it depends on internal financial management. |
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|External techniques |
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|These refer to the use of contractual relationship outside the group of companies so as to minimize the risk of foreign exchange losses. They insure against the |
|possibility the exchange losses will result from an exposed position which internal measures have not been able to eliminate. They include forward contracts, |
|borrowing short term, discounting bills receivable, factoring, government exchange risk guarantees currency options. |
|External techniques of foreign exchange exposure management use contractual relationships outside the group to reduce risk of exchange rate changes. Several |
|external techniques are available fore foreign exchange management. The firm can make a choice of that technique which is most suitable to it. |
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|TOOLS FOR FOREIGN EXCHANGE RISK MANAGEMNT |
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|Forward exchange contract |
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|A forward exchange contract is a mechanism by which one can ensure the value of one currency against another by fixing the rate of exchange in advance for a |
|transaction expected to take place at a future date. |
|Forward exchange rate is a tool to protect the exporters and importers against exchange risk under foreign exchange contract, two parties one being a banker |
|compulsorily in India, enter into a contract to buy or sell a fixed amount of foreign currency on a specific future date or future period at a predetermined rate. |
|The forward exchange contracts are entered into between a banker and a customer or between two bankers. |
|Indian exporter, for instance instead of grouping in the dark or making a wild guess about what the future rate would be, enter into a contract with his banker |
|immediately. He agrees to sell foreign exchange of specified amount and currency at a specified future date. The banker on his part agrees to buy this at a |
|specified rate of exchange is thus assured of his price in the local currency. For example, an exporter may enter into a forward contract with the bank for 3 months|
|deliver at Rs.49.50. This rate, as on the date of contract, is known as 3 month forward rate. When the exporter submits his bill under the contract, the banker |
|would purchase it at the rate of Rs.49.50 irrespective of the spot rate then prevailing. |
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|When rupee was devaluated by about 18% in July 1991, many importers found their liabilities had increased overnight. The devaluation of the rupee had effect of |
|appreciation of foreign currency in terms of rupees. The importers who had booked forward contracts to cover their imports were a happy lot. |
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|Date of delivery |
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|According to Rule 7 of FEDAI, a forward contract is deliverable at a future date, duration of the contract being computed from the spot value date of the |
|transaction. Thus, if a 3 months forward contract is booked on 12th February, the period of two months should commence from 14th February and contract will fall on |
|14th April. |
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|Fixed and option forward contracts |
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|The forward contract under which the delivery of foreign exchange should take place on a specified future date is known as ‘Fixed Forward Contract’. |
|For instance, if on 5th March a customer enters into a three months forward contract with his bank to sell GBP 10,000, it means the customer would be presenting a |
|bill or any other instrument on 7th June to the bank for GBP 10,000. He cannot deliver foreign exchange prior to or later than the determined date. |
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|Forward exchange is a device by which the customer tries to cover the exchange risk. The purpose will be defeated if he is unable to deliver foreign exchange |
|exactly on the due date. In real situations, it is not possible for any exporter to determine in advance the precise date. On which he is able to complete shipment |
|and present document to the bank. At the most, the exporter can only estimate the probably date around which he would able to complete his commitment. |
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|With a view to eliminate the difficulty in fixing the exact date of delivery of foreign exchange, the customer may be given a choice of delivery the foreign |
|exchange during a given period of days. |
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|An arrangement whereby the customer can sell or buy from the bank foreign exchange on any day during a given period of time at a predetermined rate of exchange is |
|known as ‘Option Forward Contract’. The rate at which the deal takes place is the option forward sale contract with the bank with option over November. It means the|
|customer can sell foreign exchange to the bank on any day between 1s to 30th November is known as the ‘Option Period’. |
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|Forward contract is an effective ad easily available tool for covering exchange risk. New instruments like options, futures and swaps can also be used to cover |
|exchange risks. These instruments are called financial derivatives as their value is derived from the value of some other financial contract or asset. When there |
|instrument are bought or sold for covering exchange risk they are used for ‘hedging’ the exchange risk. When they are dealt in with a view to derive profit from |
|unexpected movements in their prices or other changes in the exchange market, they are being used for speculative purposes. The scope of using these instruments for|
|speculative purposes is very much limited in India. |
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|Some other Strategies may also be adapted to avoid exchange risk. These consist in deciding on the currency of invoicing, maintaining in foreign currency and |
|deciding on the setting the debt. |
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|VOLATILITY |
|In finance, volatility most frequently refers to the standard deviation of the continuously compounded returns of a financial instrument within a specific time |
|horizon. It is used to quantify the risk of the financial instrument over the specified time period. Volatility is normally expressed in annualized terms, and it |
|may either be an absolute number ($5) or a fraction of the mean (5%). |
|Volatility Terminology |
|Volatility as described here refers to the actual current volatility of a financial instrument for a specified period (for example 30 days or 90 days). It is the |
|volatility of a financial instrument based on historical prices over the specified period with the last observation the most recent price. This phrase is used |
|particularly when it is wished to distinguish between the actual current volatility of an instrument and |
|actual historical volatility which refers to the volatiltiy of a financial instrument over a specified period but with the last observation on a date in the past |
|actual future volatilty which refers to the volatility of a financial instrument over a specified period starting at the current time and ending at a future date |
|(normally the expiry date of a option) |
|historical implied volatility which refers to the implied volatility observed from historical prices of the financial instrument (normally options) |
|current implied volatility which refers to the implied volatility observed from current prices of the financial instrument |
|future implied volatility which refers to the implied volatility observed from future prices of the financial instrument |
|For a financial instrument whose price follows a Gaussian random walk, or Wiener process, the width of the distribution increases as time increases. This is because|
|there is an increasing probability that the instrument's price will be farther away from the initial price as time increases. However, rather than increase |
|linearly, the volatility increases with the square-root of time as time increases, because some fluctuations are expected to cancel each other out, so the most |
|likely deviation after twice the time will not be twice the distance from zero. |
|Since observed price changes do not follow Gaussian distributions, others such as the Levy Distribution are often used.[1] These can capture attributes such as "fat|
|tails" although their variance remains finite. |
|Volatility for market players |
|When investing directly in a security, volatility is often viewed as a negative in that it represents uncertainty and risk. However, with other investing |
|strategies, volatility is often desirable. For example, if an investor is short on the peaks, and long on the lows of a security, the profit will be greatest when |
|volatility is highest. |
|In today's markets, it is also possible to trade volatility directly, through the use of derivative securities such as options and variance swaps. See Volatility |
|arbitrage. |
|Volatility versus direction |
|Volatility does not measure the direction of price changes, merely how dispersed they are expected to be. This is because when calculating standard deviation (or |
|variance), all differences are squared, so that negative and positive differences are combined into one quantity. Two instruments with different volatilities may |
|have the same expected return, but the instrument with higher volatility will have a larger swings in values at the end of a given period of time. |
|For example, a lower volatility stock may have an expected (average) return of 7%, with annual volatility of 5%. This would indicate returns from approximately -3% |
|to 17% most of the time (19 times out of 20, or 95%). A higher volatility stock, with the same expected return of 7% but with annual volatility of 20%, would |
|indicate returns from approximately -33% to 47% most of the time (19 times out of 20, or 95%) |
|Volatility is a poor measure of risk, as explained by Peter Carr, "it is only a good measure of risk if you feel that being rich then being poor is the same as |
|being poor then rich". |
|Volatility over time |
|Although the Black Scholes equation assumes predictable constant volatility, none of these are observed in real markets, and amongst the models are Bruno Dupire's |
|Local Volatility, Poisson Process where volatility jumps to new levels with a predictable frequency, and the increasingly popular Heston model of Stochastic |
|Volatility.[2] |
|It's common knowledge that types of assets experience periods of high and low volatility. That is, during some periods prices go up and down quickly, while during |
|other times they might not seem to move at all. |
|Periods when prices fall quickly (a crash) are often followed by prices going down even more, or going up by an unusual amount. Also, a time when prices rise |
|quickly (a bubble) may often be followed by prices going up even more, or going down by an unusual amount. |
|The converse behavior, 'doldrums' can last for a long time as well. |
|Most typically, extreme movements do not appear 'out of nowhere'; they're presaged by larger movements than usual. This is termed autoregressive conditional |
|heteroskedasticity. Of course, whether such large movements have the same direction, or the opposite, is more difficult to say. And an increase in volatility does |
|not always presage a further increase—the volatility may simply go back down again. |
|Mathematical definition |
|The annualized volatility σ is the standard deviation of the instrument's logarithmic returns in a year. |
|The generalized volatility σT for time horizon T in years is expressed as: |
|[pic] |
|Therefore, if the daily logarithmic returns of a stock have a standard deviation of σSD and the time period of returns is P, the annualized volatility is |
|[pic] |
|A common assumption is that P = 1/252 (there are 252 trading days in any given year). Then, if σSD = 0.01 the annualized volatility is |
|[pic] |
|The monthly volatility (i.e., T = 1/12 of a year) would be |
|[pic] |
|Note that the formula used to annualize returns is not deterministic, but is an extrapolation valid for a random walk process whose steps have finite variance. |
|Generally, the relation between volatility in different time scales is more complicated, involving the Lévy stability exponent α: |
|[pic] |
|If α = 2 you get the Wiener process scaling relation, but some people believe α ................
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