background theory & introduction

8/7/2019 Background Theory & Introduction

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INTRODUCTION

1.1 INTRODUCTION TO THE TOPIC

The importance of Risk Management has been extensively recognized by banks and

securities firms when deciding the amount of risk they are willing to take. Moreover, bank

regulators now put an emphasis on Risk Management practices in attempting to reduce the

fragility of financial and banking system.

India had earlier followed a tightly regulated foreign exchange regime. The liberalization

of the Indian economy started in 1991. The 1992-93 Budget provided for partial convertibility of

Indian Rupee in current accounts and, in March 1993, the Rupee was made fully convertible incurrent account. Demand and supply conditions now govern the exchange rates in our foreign

exchange market. A fast developing economy has to cope with a multitude of changes, ranging

from individual and institutional preferences to changes in technology, in economic policies, in

regulations etc. Besides, there are changes arising from external trade and capital account

interactions. These generate a variety of risks, which have to be managed. There has been a

sharp increase in foreign investment in India. Multi-national and transnational corporations are

playing increasingly important roles in Indian business. Indian corporate units are also engaging

in a much wider range of cross border transactions with different countries and products. Indian

firms have also been more active in raising financial resources abroad. All these developments

combine to give a boost to cross-currency cash flows, involving different currencies and different

countries.

With increased emphasis on Risk Management in business, the use and varieties of

derivatives have multiplied. Similarly in the management of foreign exchange, derivatives have

a significant role to play.


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1.2 NEED FOR THE STUDY

The face of banking in India is changing rapidly. The enhanced role of the banking

sector in the Indian economy, the increasing levels of deregulation along with the increasing

levels of competition have facilitated globalization, thus, leading the corporate and banks to face

various challenges and risks.

The major risk the global firms face is the exchange risk which is caused by the

fluctuations in the exchange rates. These fluctuations have created unbalanced profit and loss

patterns to the global business firms. Thus, in order to reduce these risks, the corporate make

use of the various derivative instruments available with the banks.

The utmost need for this project is to ensure whether the customers of Canara Bank are

aware of the exchange risks and the tools used to mitigate them

1.3. STATEMENT OF THE PROBLEM

International transactions are exposed to various risks like political risk, technological

risk, economical risk, etc. This study makes an attempt to know about the exchange risk and to

understand exchange Risk Management techniques employed at Canara Bank, Tirupur.


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1.4 OBJECTIVES OF THE STUDY

The objectives as this study can be as follows:

To understand the Risk Management Techniques employed at Canara Bank, Tirupur.

To understand the process involved in the Forward contracts.

To understand the process involved in the Cross currency contracts.

To understand the process involved in the Options.

To identify the level of awareness about hedging tools among Tirupur exporters availing

hedging tools in Canara Bank, Tirupur. (viz., Main branch, SME branch, Perumanallur

branch)

To identify the problems associated with Pre-Shipment and Post-Shipment advances

available to their clients.


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1.5 RESEARCH METHODOLOGY

It is a descriptive cum Analytical study. Both primary data as well as secondary data are

used for analysis of this study.

1.5.1 COLLECTION OF DATA:

The data collected for this project is primary as well as secondary data.

Primary data:

A Direct personal interview was made to the professionals dealing with exports

of their company. This is the main source of Primary data.

Secondary Data:

The secondary data was collected from internal sources. It was collected from the

banks books of accounts, organizational file, official records, preserved information in

the banks database and their official website.

1.5.2 SAMPLING PLAN:

Sampling Units:

28 corporate customers dealing with export were interviewed. The basic criterion

is that their company should maintain an account with the Indian Canara Banks

FEXCELL, Tirupur.


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Research Instrument:

The managerialprofessionals were interviewed in the bank while coming for

their day-to day activity. Some of the exporters are interview in their office by the

researcher.

1.5.3 SAMPLE SIZE:

The sample size for this project is 28 respondents. The entire customers who deal with

export business was considered for this study. There are totally 42 exporter customer are

availing hedging tools among them only 30 exporters are active participant. Rest 12 exporters are

not actively involved in using hedging tools and few exporters switched over their banks. Hence

among 30 exporters survey was contacted by the exporter in that 2 exporters are interested in

responding to the questionnaire.

1.6 LIMITATIONS OF THE STUDY:

The operations of the Canara Bank are subject to certain limitations which are

identified as follows:

The study is done only at a micro level and is restricted to the Tirupur branch. (viz., Main

branch, SME branch, Perumanallur branch)

The customers were less in number and whatever analyzed was limited to that extent.

The secondary data collected and taken into consideration in order to fulfill the objectives

of this project includes the data recorded in their books of accounts and the data available


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from the website of the Bank. The data used for analysis cover a period of 2 years

starting from January, 2008 to December, 2009 and whatever analyzed is limited to the

same period.

The scope is limited to the types of foreign currency accounts that are currently

maintained in this branch

1.7. CHAPTERIZATION:

Chapter 1: This chapter mainly deals with an introduction to the topic of study. It gives an

idea about the primary objective of the study and the problem to be addressed. It says about the

research methodology and tools used for analysis.

Chapter 2: This chapter gives an introduction to the banking industry and a detailed the

profile of the Canara Bank. It also gives an in depth study about the organization viz., Canbank.

Chapter 3: This chapter provides the conceptual framework about the topic of study. It givesan introduction to the International Business. It explains about the Risk Management techniques

and the derivatives used to mitigate the exchange risk. It also gives an insight into various types

of exchange rates, Pre-Shipment and Post-Shipment advances. It justifies the need for the study.

Chapter 4: This chapter provides the detailed analysis of the primary data collected through

Direct personal interview and secondary data collected from the organization. It is followed by

interpretation of the same.

Chapter 5: This chapter indicates the summary of findings, suggestions and conclusion of the

analysis done in Chapter 4.


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CHAPTER 2

2.1 PROFILE OF INDIAN BANKING INDUSTRY

The Indian Banking industry, which is governed by the Banking Regulation Act of India,

1949 can be broadly classified into two major categories, non-scheduled banks and scheduled

banks. Scheduled banks comprise commercial banks and the co-operative banks. In terms of

ownership, commercial banks can be further grouped into nationalized banks, the State Bank of

India and its group banks, regional rural banks and private sector banks (the old/ new domestic

and foreign). These banks have over 67,000 branches spread across the country.

The first phase of financial reforms resulted in the nationalization of 14 major banks in

1969 and resulted in a shift from Class banking to Mass banking. This in turn resulted in a

significant growth in the geographical coverage of banks. Every bank had to earmark a minimum

percentage of their loan portfolio to sectors identified as priority sectors. The manufacturing

sector also grew during the 1970s in protected environs and the banking sector was a critical

source. The next wave of reforms saw the nationalization of 6 more commercial banks in 1980.

Since then the number of scheduled commercial banks increased four-fold and the number of

bank branches increased eightfold.

After the second phase of financial sector reforms and liberalization of the sector in the

early nineties, the Public Sector Banks (PSB) s found it extremely difficult to compete with the


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new private sector banks and the foreign banks. The new private sector banks first made their

appearance after the guidelines permitting them were issued in January 1993. Eight new private

sector banks are presently in operation. These banks due to their late start have access to state-of

the-art technology, which in turn helps them to save on manpower costs and provide better

services.

During the year 2000, the State Bank of India (SBI) and its 7 associates accounted for a

25 percent share in deposits and 28.1 percent share in credit. The 20 nationalized banks

accounted for 53.2 percent of the deposits and 47.5 percent of credit during the same period. The

share of foreign banks (numbering 42), regional rural banks and other scheduled commercial

banks accounted for 5.7 percent, 3.9 percent and 12.2 percent respectively in deposits and 8.41

percent, 3.14 percent and 12.85 percent respectively in credit during the year 2000.

Current Scenario

The industry is currently in a transition phase. On the one hand, the PSBs, which are the

mainstay of the Indian Banking system, are in the process of shedding their flab in terms of

excessive manpower, excessive non Performing Assets (NPAs) and excessive governmental

equity, while on the other hand the private sector banks are consolidating themselves through

mergers and acquisitions.

Private sector Banks have pioneered internet banking, phone banking, anywhere banking,

mobile banking, debit cards, Automatic Teller Machines (ATMs) and combined various other

services and integrated them into the mainstream banking arena, while the PSBs are still

grappling with disgruntled employees in the aftermath of successful VRS schemes. Also,

following Indias commitment to the W To agreement in respect of the services sector, foreign

banks, including both new and the existing ones, have been permitted to open up to 12 branches

a year with effect from 1998-99 as against the earlier stipulation of 8 branches.

Meanwhile the economic and corporate sector slowdown has led to an increasing number

of banks focusing on the retail segment. Many of them are also entering the new vistas of


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Insurance. Banks with their phenomenal reach and a regular interface with the retail investor are

the best placed to enter into the insurance sector. Banks in India have been allowed to provide

fee-based insurance services without risk participation invest in an insurance company for

providing infrastructure and services support and set up of a separate joint-venture insurance

company with risk participation.

Governmental Policy

After the first phase and second phase of financial reforms, in the 1980s commercial

banks began to function in a highly regulated environment, with administered interest rate

structure, quantitative restrictions on credit flows, high reserve requirements and reservation of a

significant proportion of lendable resources for the priority and the government sectors. The

restrictive regulatory norms led to the credit rationing for the private sector and the interest rate

controls led to the unproductive use of credit and low levels of investment and growth. The

resultant financial repression led to decline in productivity and efficiency and erosion of

profitability of the banking sector in general. This was when the need to develop a sound

commercial banking system was felt. This was worked out mainly with the help of the

recommendations of the Committee on the Financial System (Chairman: Shri M. Narasimham),

1991. The resultant financial sector reforms called for interest rate flexibility for banks, reduction

in reserve requirements, and a number of structural measures. Interest rates have thus been

steadily deregulated in the past few years with banks being free to fix their Prime Lending Rates

(PLRs) and deposit rates for most banking products. Credit market reforms included introduction

of new instruments of credit, changes in the credit delivery system and integration of functional

roles of diverse players, such as, banks, financial institutions and non banking financial

companies (NBFCs). Domestic Private Sector Banks were allowed to be set up, PSBs were

allowed to access the markets to shore up their Cars.

Significantly, the RBI has the tenth largest gold reserves in the world after spending US$

6.7 billion towards the purchase of 200 metric tonnes of gold from the International Monetary


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Fund (IMF) in November 2009. The purchase has increased the country's share of gold holdings

in its foreign exchange reserves from approximately 4 per cent to about 6 per cent.

In the annual international ranking conducted by UK-based Brand Finance Plc, 20 Indian

banks have been included in the Brand Finance Global Banking 500. In fact, the State Bank of

India (SBI) has become the first Indian bank to be ranked among the Top 50 banks in the world,

capturing the 36th rank, as per the Brand Finance study. The brand value of SBI increased from

US$ 1.5 billion in 2009 to US$ 4.6 billion in 2010. ICICI Bank also made it to the Top 100 list

with a brand value of US$ 2.2 billion. The total brand value of the 20 Indian banks featured in

the list stood at US$ 13 billion.

Meanwhile, loan disbursement from scheduled commercial banks which included

regional rural banks as well posted a growth of 16.04 per cent by March 12, 2010, on a year-on-

year basis, as per the latest data released by RBI. The RBI had earlier predicted that the credit

growth during 2009-10 would be around 16 per cent.

Following the financial crisis, new deposits have gravitated towards public sector banks.

According to RBI's 'Quarterly Statistics on Deposits and Credit of Scheduled Commercial

Banks: September 2009', nationalised banks, as a group, accounted for 50.5 per cent of the

aggregate deposits, while State Bank of India (SBI) and its associates accounted for 23.8 percent. The share of other scheduled commercial banks, foreign banks and regional rural banks in

aggregate deposits were 17.8 per cent, 5.6 per cent and 3.0 per cent, respectively.

With respect to gross bank credit also, nationalised banks hold the highest share of 50.5

per cent in the total bank credit, with SBI and its associates at 23.7 per cent and other scheduled

commercial banks at 17.8 per cent. Foreign banks and regional rural banks had a share of 5.5 per

cent and 2.5 per cent respectively in the total bank credit.

The report also found that scheduled commercial banks served 34,709 banked centres. Of

these centres, 28,095 were single office centres and 64 centres had 100 or more bank offices.

Foreign exchange reserves were up by US$ 1.69 billion to US$ 272.8 trillion, for the

week ending June 11, on account of revaluation gains. June 21, 2010.


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Major Developments:

The Monetary Authority of Singapore (MAS) has provided qualified full banking (QFB)

privileges to ICICI Bank for its branch operations in Singapore. Currently, only SBI had QFB

privileges in country.

The Indian operations of Standard Chartered reported a profit of above US$ 1 billion for

the first time. The bank posted a profit before tax (PAT) of US$ 1.06 billion in the calendar year

2009, as compared to US$ 891 million in 2008.

Punjab National Bank (PNB) plans to expand its international operations by foraying into

Indonesia and South Africa. The bank is also planning to increase its share in the international

business operations to 7 per cent in the next three years.

The State Bank of India (SBI) has posted a net profit of US$ 1.56 billion for the nine

months ended December 2009, up 14.43 per cent from US$ 175.4 million posted in the nine

months ended December 2008.

Amongst the private banks, Axis Bank's net profit surged by 32 per cent to US$ 115.4

million on 21.2 per cent rise in total income to US$ 852.16 million in the second quarter of 2009-

10, over the corresponding period last year. HDFC Bank has posted a 32 per cent rise in its net

profit at US$ 175.4 million for the quarter ended December 31, 2009 over the figure of US$

128.05 million for the same quarter in the previous year.

2.2 PROFILE OF CANARA BANK

Widely known for customer centricity, Canara Bank was founded by Shri Ammembal

Subba Rao Pai, a great visionary and philanthropist, in July 1906, at Mangalore, then a small port

in Karnataka. The Bank has gone through the various phases of its growth trajectory over

hundred years of its existence. Growth of Canara Bank was phenomenal, especially after

nationalization in the year 1969, attaining the status of a national level player in terms of


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geographical reach and clientele segments. Eighties was characterized by business diversification

for the Bank. In June 2006, the Bank completed a century of operation in the Indian banking

industry. The eventful journey of the Bank has been characterized by several memorable

milestones. Today, Canara Bank occupies a premier position in the comity of Indian banks. With

an unbroken record of profits since its inception, Canara Bank has several firsts to its credit.

These include:

Launching of Inter-City ATM Network

Obtaining ISO Certification for a Branch

Articulation of Good Banking Banks Citizen Charter

Commissioning of Exclusive Mahila Banking Branch

Launching of Exclusive Subsidiary for IT Consultancy

Issuing credit card for farmers

Providing Agricultural Consultancy Services

Over the years, the Bank has been scaling up its market position to emerge as a major 'Financial

Conglomerate' with as many as nine subsidiaries/sponsored institutions/joint ventures in India

and abroad. As at March 2010, the Bank has further expanded its domestic presence, with 3043 branches spread across all geographical segments. Keeping customer convenience at the

forefront, the Bank provides a wide array of alternative delivery channels that include over 2000

ATMs- one of the highest among nationalized banks- covering 728 centres, 1959 branches

providing Internet and Mobile Banking (IMB) services and 2091 branches offering 'Anywhere

Banking' services. Under advanced payment and settlement system, all branches of the Bank

have been enabled to offer Real Time Gross Settlement (RTGS) and National Electronic Funds

Transfer (NEFT) facilities.

Not just in commercial banking, the Bank has also carved a distinctive mark, in various

corporate social responsibilities, namely, serving national priorities, promoting rural

development, enhancing rural self-employment through several training institutes and

spearheading financial inclusion objective. Promoting an inclusive growth strategy, which has

been formed as the basic plank of national policy agenda today, is in fact deeply rooted in the


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Bank's founding principles. "A good bank is not only the financial heart of the community,

but also one with an obligation of helping in every possible manner to improve the

economic conditions of the common people". These insightful words of our founder continue

to resonate even today in serving the society with a purpose. The growth story of Canara Bank in

its first century was due, among others, to the continued patronage of its valued customers,

stakeholders, committed staff and uncanny leadership ability demonstrated by its leaders at the

helm of affairs. We strongly believe that the next century is going to be equally rewarding and

eventful not only in service of the nation but also in helping the Bank emerge as a "Global Bank

with Best Practices". This justifiable belief is founded on strong fundamentals, customer

centricity, enlightened leadership and a family like work culture.

2.2.1 HISTORY

Founded as 'Canara Bank Hindu Permanent Fund' in 1906, by late Sri. Ammembal Subba Rao

Pai, a philanthropist, this small seed blossomed into a limited company as 'Canara Bank Ltd.' in

1910 and became Canara Bank in 1969 after nationalization.

"A good bank is not only the financial heart of the community, but also one with an obligation

of helping in every possible manner to improve the economic conditions of the common people"

- A. Subba Rao Pai.

Founding Principles

1. To remove Superstition and ignorance.

2. To spread education among all to sub-serve the first principle.

3. To inculcate the habit of thrift and savings.

4. To transform the financial institution not only as the financial heart of the community but

the social heart as well.

5. To assist the needy.

6. To work with sense of service and dedication.

7. To develop a concern for fellow human being and sensitivity to the surroundings with a

view to make changes/remove hardships and sufferings.


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Sound founding principles, enlightened leadership, unique work culture and remarkable

adaptability to changing banking environment have enabled Canara Bank to be a frontline

banking institution of global standards.

CHAPTER 3

FOREIGN EXCHANGE RISK MANAGEMENT IN BANKS AN OVERVIEW

3.1 INTRODUCTION TO INTERNATIONAL BUSINESS

An organization to become global does not mean that it shall necessarily do business

globally but it is essential that it should be able to survive the global competition. Globalization

is important because a Company that fails to go global is in the danger of losing its domestic

business to competitors with lower costs, greater experience, better products and in a nutshell,

more value for the customer. Despite all the harmful effects and criticisms against it,

globalization has come to stay; it is, indeed, becoming more pervasive.

A firm may be motivated or provoked to go international due to the pull factors (those

forces of attraction which pull the business to the foreign market) or push factors (compulsions

of the domestic market which prompt companies to go global).

The degree and nature of involvement in international business or the international

orientation of companies vary widely. The important forces driving globalization are economic

policy liberalization, growth of MNCs, technological advances, transportation and

communication revolution, and increasing competition.

On the other hand there are also forces which restrain globalization. Factors which

restrain the globalization trend include government policies and controls which restrain cross-


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border business, social and political opposition against foreign business, management myopia,

which comes in the way of a global orientation, etc.

A firm which plans to go international has to make a series of strategic decisions. They

are international business decision, market selection decision, foreign market entry and operating

decisions, marketing mix decision, and international organization decision.

3.2 Introduction to Foreign Exchange

Any economic transaction that happens between residents of two countries involves

exchange of one currency into another. A resident may import goods or services from abroad or

export them from his country. An investor may find that investing abroad gives him higher

returns. A tourist who visits another country requires the currency of the country he visits to

meet his expenses there. In all these cases, the source of purchasing power is available in one

currency whereas its use is in another currency. Each currency has geographical jurisdiction to

function as legal tender in settlement of debts. Beyond the country of issue, barring few

exceptions, a currency cannot function as legal tender. When the above transactions are

executed, through the intermediation of banks, currencies are converted from one form to

another. These transactions can broadly be classified into trade transactions and non-trade

transactions. Import and export of goods and services are trade transactions. Going abroad on

tour or getting medical treatment abroad are examples of non-trade transactions.

3.2.1 Foreign Exchange: Meaning

Foreign exchange is a mechanism by which the currency of one country gets converted

into the currency of another country. Foreign exchange include foreign currency, balances kept

abroad, instruments payable in foreign currencies and instruments drawn abroad but payable in

Indian currency. It also refers to foreign currencies themselves, since they cannot function as

legal tender, but yet serve the purpose of exchange of values.


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3.2.2 Uses of Foreign Exchange

Foreign exchange is earned by the country by transactions that involve inflow of

purchasing power into the country. These may be export of goods and services, foreign

investments in the country, borrowings from abroad, etc. Foreign exchange is spent on payment

for import of goods and services, investments abroad, lending abroad, etc. Primarily, foreign

exchange is earned by exports and is spent on imports. It cannot be created within the country.

Therefore, the efforts of every country would be to balance the earnings and spending of foreign

exchange. Since spending is easier than earning, many countries face the problem of shortage of

foreign exchange. Therefore the need arises for regulating or controlling of foreign exchange.

3.2.3 History of Exchange Control in India

Exchange control was introduced in India on September 1939 on the outbreak of the

Second World War. In the closing stages of the war, it became clear that control over foreign

exchange transactions would have to continue in some form or the other in the post-war period in

the interest of making the most prudent use of foreign exchange resources. Therefore, it was

decided to place the control on a statutory basis and the Foreign Exchange Regulation Act

(FERA) of 1947 was enacted.

It was found necessary to continue exchange control introduced during the Second World

War on a systematic and long-term basis, in view of the substantial requirements of foreign

exchange for the planned developmental efforts undertaken. Over the years, the scope if

exchange for the planned development efforts undertaken. Over the years, the scope of exchange

control in India steadily widened and the regulations became progressively more elaborate with

the increasing foreign exchange outlays under successive Five-Year plans and the relatively

inadequate earning of foreign exchange. Periodically, appraisals and reviews of policies and

procedures were undertaken and such modifications made as were warranted by changes in the

national policies and priorities, and fluctuations in the level of foreign exchange reserves caused

by both national and international economic and other developments. Under these circumstances

the Foreign Exchange Regulation Act (FERA) of 1973 was passed to replace the Act of 1947.


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FERA: Definition

The purpose of enactment of this act was to consolidate and amend the law regulating

certain payments, dealing in foreign exchange and securities transactions indirectly affecting

foreign exchange and the import and export of currency and bullion, for the conservation of the

foreign exchange resources of the country and the proper utilization thereof in the interest of the

economic development of the country.

Transformation of FERA to FEMA

The Foreign Exchange Regulation Act (FERA) of 1973 was reviewed in 1993 and

several amendments were enacted as part of the on-going process of economic liberalization

relating to foreign investments and foreign trade for closer interaction with the world economy.

Significant developments took place after 1993such as substantial increase in our foreign

exchange reserves, growth in foreign trade, rationalization of tariffs, current account

convertibility, liberalization of Indian investments abroad, increased access to external

commercial borrowings by Indian corporate and participation of foreign institutional investors in

our stock markets. This needed a change in the outlook of the statue governing the foreign

exchanges transactions from one of control and conservation to that if encouragement and

promotion. The Foreign Exchange Management Act, 1999 was introduced to provide the

necessary change.

FEMA: Definition

The Foreign Exchange Management Act, (FEMA) 1999 seeks to bring the law on the

subject up to date keeping in view the changed environment. This Act aims at consolidating and

amending the law relating to Foreign Exchange with the objective of facilitating external trade

and payments and for promoting the orderly development and maintenance of foreign exchange

markets in India.


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3.2.4 Foreign exchange risk management

Foreign exchange is considered as a rare commodity and was subject to strict control in

almost all countries of the world till 1970s. Exchange control was the order of the day. Today,

we talk of exchanges management and not exchange control. But the fact is that foreign

exchange management from the national point of view is only exchange control or regulation,

though in a diluted form.

The term exchange control refers to the control, by the Government or centralized agency

of transaction involving foreign exchange. In a broad sense, any stipulation or regulation which

restricts the free play of forces in the foreign exchange market can be termed exercise of

exchange control. The rate of exchange under exchange control regime tends to be different

from the one that would exist in the absence of such control.

The origin of exchange control can be traced to 19th century. After the First World War,

many countries of Europe found themselves with depleted gold reserves and foreign exchange.

They imposed payment restrictions to prevent massive capital withdrawals and stability in the

domestic economy. Since then exchange control has been adopted by a large number of

countries and for different purposes.

With the onset of globalization and liberalization beginning at the commencement of

1990s the tendency throughout the world has been that of relaxing exchange control. Even

earlier, some countries like USA proclaimed that they had no exchange control. But the fact is,

even today, exchange control exits in all countries, with varying intensity.

3.3 Risk Management

The face of banking in India is changing rapidly. The enhanced role of the banking sector

in the Indian economy, the increasing levels of deregulation along with the increasing levels of

competition have facilitated globalization of the India banking system and placed numerous


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demands on banks. Operating in this demanding environment has exposed banks to various

challenges and risks.

TYPES OF RISK

The banking industry has long viewed the problem of Risk Management as the need to

control four of the above risks which make up most, if not all, of their risk exposure, viz., credit,

interest rate, foreign exchange and liquidity risk. While they recognize counterparty and legal

risks, they view them as less central to their concerns.

3.3.1 DERIVATIVES USED FOR MITIGATION OF RISK:

A derivative is a financial instrument whose value is dependent on some other

fundamental variable. With increased emphasis on Risk Management in business, the use and

varieties of derivatives have multiplied. Derivatives are now available for almost all risks in

business. In the management of foreign exchange risk also, derivatives have important role to

play. Traditionally Forward contracts were the instruments used by corporate to hedge their

currency exposures. Forward contract is also a derivative. Therefore, corporate were using

derivatives even before the term gained currency. The scope of currency Risk Management has

improved now with the availability of other derivatives like options, futures and swaps in

addition to the traditional Forward contracts.

TYPES OF INSTRUMENTS

Based on the nature of the instruments available in the currency markets, the contract

terms have been classified as Forwards, futures, options and swaps.


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Forward contracts:

A Forward contract is an arrangement whereby an agreed amount of foreign currency is

bought or sold for a specified future delivery at a predetermined rate of exchange. The parties to

the contract may be a bank and its customers. The contract may also be between two banks. A

Forward contract is an OTC (Over The Counter) product and is available at the counters of the

banks dealing in foreign exchange. An exporter who had a receivable due six months hence may

hedge his position by entering into a Forward contract when he apprehends that the currency in

which the transaction is denominated will depreciate in future. The size and other terms of

contract can be tailor-made to the requirements of the customer. Hence Forward contracts

provide perfect hedge. But the opportunity to gain from favorable movement in the rates is also

lost.

Futures:

Futures is a standardized form of Forward contracts available at specified exchanges.

The size of the contract and the due date are fixed by the exchange concerned. For a hedger,

futures does not afford perfect cover since he has to decide to under-cover or over-cover his

actual exposure. For instance, the futures in Euro in Chicago exchange is of the size of EUR100,000 and is available for delivery in March, June, September and December months. A fund

manager finds that his exposure is EUR 150,000 and due in August. He can take position in one

Euro futures (under cover) or two Euro futures (over-cover). The futures cab be bought due June

(short cover) or due September (extended cover). The advantage of futures is that since it is a

standardized product, the cost of hedging may be cheaper as compared to other derivatives.

Options:

Both forwards and futures bestow the right to buy or sell a foreign currency; they also

impose an obligation to execute the contract on the due date. Option is a derivative which

gives the buyer a right to buy or see a certain amount of specified foreign currency on a specified

future date at a pre-determined date, but without any obligation to do so. On the due date, the


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buyer of the option can review the situation in the market and exercise his right and let the option

if it is advantageous to him; otherwise he can simply renounce his right and let the option expire.

The option, of course, comes with a cost. It is available for the consideration of a premium

payable upfront and non refundable whether the option is exercises or not on the due date.

Swaps:

Financial swap is an arrangement whereby the financial streams are exchanges between

two parties. The purpose is to use their comparative advantage in the market for raising the

funds and use it to their mutual advantage. Both the parties may benefit in the form of lowered

cost of borrowing. The swaps are also now offered by banks as products whereby the borrowers

can exchange the fixed interest borrowings into floating rates and vice versa. The exchange can

also be financial streams in two currencies. They may be classified into two types:

Credit Default Swaps - Credit derivatives are being used by almost all the banks now. Out of a

total of $250 trillion of derivative contracts traded round the world, more than 50% are in form

of credit derivatives. Then banks are using swaps for match their asset - liability mismatch.

Interest Rate Swaps - A bank having a fixed income and floating outflow can go in for a swap

to get fixed outflow. Similarly, swaps can be arranged to hedge currency risks. Universal

banking system is now spreading fast. This is diversifying the bank's operational risk.

FORWARD CONTRACTS: A DETAILED STUDY

FEATURES:

Forward exchange contract is a device which can afford adequate protection to an

importer or an exporter against exchange risk. Under a Forward exchange contract a banker and

a customer or another banker enter into contract to buy or sell a fixed amount of foreign currency

on a specified future date at a predetermined rate of exchange. Our exporter, for instance,

instead of examining in the dark or making a wild guess about what the future rate would be, he


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enters 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. The exporter thus assures of his price in the local currency.

DATE OF DELIVERY:

According to rule 7 of FEDAI, a Forward contract is a deliverable at a future date,

duration of the contract being computed from the spot value date of the transaction. Thus, if a 2

months Forward contract is booked on 12th February, the period of two months should

commence from 14th February and the Forward contract will fall due on 14th April.

CLASSIFICATION OF FORWARD CONTRACT

The Forward contracts may be classified based on their nature and the time the amount is

received. Based on their nature, Forward contracts may be of two types Forward sale contract

and Forward purchase contract. Based on the time the amount is delivered, they may be

classified as fixed and Option Forward contracts.

Forward sale contract:

Forward sale contract is a method for hedging the exchange risk that involves an

agreement between a banker and an importer to sell particular currency at a specified rate and a

future time.

Forward purchase contract:

Forward purchase contract is a method for hedging the exchange risk that involves an

agreement between a banker and an importer to sell particular currency at a specified rate and a

future time.

Fixed and Option Forward contract:


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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

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.

HEDGING WITH FORWARD CONTRACTS:

Forward contract is the traditional method by which exporters and importers were

hedging their foreign currency exposures. It affords perfect hedge for foreign currency

exposures but it also takes away the opportunity to make profits from favorable movements in

exchange rate.

This uncertainty about the rate that would prevail on a future date is known as exchange

risk. For the exporter the exchange risk is that the foreign currency in which the transaction is

designated may depreciate in future and may bring less than expected realization in local

currency terms

The importer faces exchange risk when the transaction is designated in a foreign

currency. The risk is that the foreign currency may appreciate in value and he may be compelled

to pay in local currency an amount higher than that was originally contemplated. Importers

generally make arrangements for loans for payment for the imports. If foreign currency

appreciates subsequent to the arrangement of the loan, the importer may find that the resources

are not sufficient to meet the importer bill putting him in a difficult situation.

BOOKING OF FORWARD CONTRACT:

Forward contracts can be booked by paying a sum of Rs. 500 per contract irrespective to

the amount of the transaction. The regulations relating to booking of Forward contracts are

given below:


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The bank, through verification of documentary evidence, should be satisfied about the

genuineness of the underlying exposure.

The maturity of the hedge should not exceed the maturity of the underlying transaction.

The currency of hedge and tenor are left to the choice of the customer.

Where the exact amount of the underlying transaction is not ascertainable, the contract

can be booked on the basis of a reasonable estimate.

Foreign currency loans/bonds will be eligible for hedge only after final approval is

accorded by the Reserve Bank, where such approval is necessary.

In the case of Global Depository Receipts (GDRs), the issue price should have been

finalized.

Substitution of contracts for hedging trade transactions may be permitted by an

authorized dealer on being satisfied with the circumstances under which such substitution

has become necessary.

CANCELLATION AND RE-BOOKING:

The Forward contracts may be cancelled or re-booked. When a Forward contract

is cancelled the customer has to pay an amount of Rs. 1000.

All cross currency Forward contracts (not involving rupee) can be freely re-booked on

cancellation.

All Forward contracts with rupee as one of the currencies, booked to cover foreign

exchange exposure falling due within one year can be freely cancelled and re-booked.

All Forward contracts, involving the rupee as one of the currencies, booked by residents


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to hedge current account transaction, regardless of tenor, may be allowed to be cancelled

and rebooked freely. The exposure can again be covered by the customer with the same

or another bank. Banks will have to ensure that a genuine exposure to the extent of the

amount of the Forward contract in respect of a permissible transaction continues to exist.

This relaxation is not applicable to Forward contracts booked on past performance basis

without documents as also Forward contracts booked to hedge transactions denominated

in foreign currency but settled in Indian rupees, where the current restrictions will

continue. Further, the facility of cancellation and rebooking is not permitted unless the

facility of cancellation and rebooking of Forward contracts is extended to these

transactions subject to the condition that total Forward contracts rebooked shall not

exceed the total of the un-hedged exposures falling due within one year (April-March).

For monitoring the limit banks may obtain suitable declaration from the customer about

the contracts rebooked with other banks.

A Forward contract cancelled with one bank can be rebooked with another bank subject

to the following conditions:

(i) The switch is warranted by competitive rates on offer, termination of banking

relationship with the bank with whom the contract was originally booked, etc.;

(ii)The cancellation and rebooking are done simultaneously on the maturity date of

the contract; and

(iii) The responsibility of ensuring that the original contract has been cancelled rests with

the bank who undertakes re-booking of the contract.

3.4 CATEGORISATIONOF EXCHANGE RATES:

The exchange rates may be classified into two types- Fixed Exchange Rates, Floating

Exchange Rates and Managed Floating Rates.


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3.4.1 FIXED EXCHANGE RATES:

Fixed exchange rates refer to the system under the gold standard where the rate of

exchange tends to stabilize around the mint par value. Any large variation of the rate of

exchange from the mint par value would entail flow of gold into or from the country. This

would have the effect of bringing the exchange rate back to mint par value.

In the present day situation where gold standard no longer exists, fixed rates of exchange

refer to maintenance of external value of the currency at a predetermined level. Whenever the

exchange rate differs from this level it is corrected through official intervention. For example,

when IMF was instituted, every member-country was required to declare the value of the

currency in terms of gold and US Dollars (known as par value). The actual market rates were

allowed to fluctuate only within narrow band of margin from this level.

The par value system was abolished with the second amendment to the Articles of IMF in

1978. Still the system of fixed rates continues in many countries in the form of pegging their

currencies to a major currency. For instance, countries like Egypt and Pakistan have pegged the

value of their currencies to US dollar. That is, the values of these national currencies are fixed in

terms of US dollar and are allowed to vary in the exchange markets only within a narrow band.

3.4.2 FLOATING EXCHANGE RATES:

Free or floating exchange rates refer to the system where the exchange rates are

determined by the conditions of demand for and supply of foreign exchange in the market. The

rates are free to fluctuate according to the changes in demand and supply forces with no

restrictions on buying and selling of foreign currencies in the exchange market.

Under floating rates no par value is declared and the central bank does not intervene in

the market. Any disparity in the balance of payments is adjusted through the changes in

exchange rate that take place automatically in the market. Because the central bank does not

intervene in the market there is no change in the exchange reserves of the country.


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3.7 PRE-SHIPMENT CREDIT:

A Pre-Shipment credit otherwise known as packing credit is any loan or advance granted

to an exporter for fnancing the purchase, processing, manufacturing or packing of goods meant

for export or working capital expenses rendered towards rendering of sercies abroad. In other

words, it is the facility extended to the exporters before and till the goods are shipped for exports.

Eligibility:

A Pre-shipement credit will be granted to exports based on their request if they have the

following documents.

The letter of credit established by the banks of standing abroad in favour of the exporters.

It can also be granted on the strength of an export order.

Type of Account:

Packing credit will be given in the form of loan

The Pre-shipement loan will be available for a maximum of 180 days on a concessional

rate.

The concessional rate will be withdrawn for the nest 180 days.

The amount advanced towards the packing credit should not exceed 75% of the FOB,

CIF or CFR amount.

That 75% of amount will be calculated at the notional rate given by the RBI.

Repayment:

The packing credit account should be repaid out of the

Proceeds of foreign bills of exchange drawn under the export contract.

Export incentives like duty drawback


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Can also be paid out of the balances of the EEFC account (subject to mutual agreement

between the exporter and the bank)

3.8 POST-SHIPMENT FINANCE:

A Post-Shipment finance is a credit facility extended to the exporters from the time goods are

shipped and till the export proceeds are realised. Post-Shipment finance may take any of the

following forms:

Negotiation of a bill drawn under a letter of credit

Purchase of a bill drawn under a letter of credit

Advance against bill sent for collection

Advance against duty drawback.

POST-SHIPMENT FINANCE IN FOREIGN CURRENCY:

Post-Shipment finance in foreign currency can be made available through

Use of on-shore foreign currency funds

Banks raising foreign currency funds abroad

Exporters raising foreign currency funds abroad

Interest is charged at non exceeding LIBOR plus 1% for period up to 90 days.


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CHAPTER 4

ANALYSIS AND INTERPRETATION

Based on the information collected using through the telephonic interview as well as the

secondary data from different sources, we can segregate the problems with regard to the Forward

contracts, NRE accounts, inflow and outflow of the currencies and their impact on the Risk

Management of the customers of the Bank. Each one are addressed separately and the analysis is

carried out.

4.1 Forward Contracts as a risk mitigation tool:

It is a feature that can be utilized by Indian residents who engage in exports and imports

of goods as well as other transactions that involves them to deal with the foreign currency. This


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enables them to be aware of the exchange risks involved in their transactions. Any person who

get some amount in the form of foreign currency for their export transactions or any other

remittances can enter into a Forward contract. It is simply hedging their risk so that they need

not gamble with the future events.

A quick example would help to illustrate the mechanics of a cash settled Forward

contract done in the foreign exchange branch. Let us assume that the exchange rate is USD 1 =

Rs. 45. On January 1, 2009 National Sewing Thread Co. Ltd., agrees to buy from James

Chadwick & Bros. Ltd.,1000 yarns of cotton on April 1, 2009 at a price of $ 30.00 per yarn(Total Value is USD 30000 i.e Rs.13,50,000 in terms of Indian currency on the day which the

transaction is entered). Here the National Sewing Thread Co. Ltd. has to pay Rs. 13,50,000 to

James Chadwick & Bros. Ltd., on April 1, 2009. If on April 1, 2009 the spot price (also known

as the market price) USD 1 = Rs. 44, the National Sewing Thread Co. Ltd., will incur loss. They

will get only an amount of Rs.13,20,000. The remaining amount of Rs.30000 is a loss for them.

Therefore, in order to cover this risk aroused due to exchange rate fluctuation the company can

enter into a Forward contract with the bank.

The company can enter into the Forward contract when they are sure of getting a

particular amount on a particular date. This contract helps them to be on the safer side and they

are assured of that particular amount on which they have entered into.

There of two type of Forward contracts- (i) Forward Purchase contract and Forward Sale

contract. The term purchase and sale are used with respect to the banker. In a Forward purchase

contract the banker agrees to purchase a certain amount of foreign currency from the exporter.

Here the exporter hedges his risk. In a Forward sale contract the banker agrees to sell a certain

amount of foreign currency to the importer. Under this case the importer hedges the risk.

When we analyze a Forward contract and find the difference between the forward rate

(the rate at which the agreement is entered into) and the real exchange rate or the spot rate, the

contracts would end up at a Premium or Discount.


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Forward contracts ended in Premium:

In case of a Forward purchase contract, if the forward rate is more than the spot rate and

in case of a Forward sale contract, if the spot rate is more than the forward rate then the contract

results in a Premium.

Forward contracts ended at Discount:

In case of a Forward purchase contract, if the spot rate is more than the forward rate and

in case of a Forward sale contract, if the forward rate is more than the spot rate the contract ends

at a Discount.

background theory & introduction

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