Hi, here is some matter below on forex risk mgmt. i found it from internet itself.
FOREX RISK MANAGEMENT
OBJECTIVES BEHIND FOREX MANAGEMENT
COST REDUCTION
CONTAIN LOSSES
OPTIMISING EXCHANGE GAIN
PROTECT OPERATING PROFIT
ACHIEVE BUDGETS AND TARGETS
INSURE AGAINST ADVERSE EXCHANGE RATE MOVEMENTS
HOW TO ACHIEVE THESE OBJECTIVES?
Determine the nature of exposure
Evaluate the risks and rewards
Decide targets & strategies to safeguard against currency risk
Formulate policies for day-to-day operations
Strong MIS Reporting system
Periodical review of performance & strategy
Single treasury concept for forex & money market
KEY FACTORS FOR AN EFFECTIVE STRATEGY
Management’s attitude towards risk
Type of exposure – Tenure & Cost
Firm’s willingness to devote the amount and quality of resource to exposure management function
Access to various markets & instruments such as forwards, options, futures etc and there implications
Choice of currency - Dollar / Non- Dollar
Gross or Net Exposure to be managed
NATURE OF RISK
CURRENCY RISK
- Dollar vs. INR - a) Spot b) Forward
- Cross Currency - DUAL Exposure
INTEREST RATE RISK
Domestic & International
OTHER ECONOMIC RISK
Competitor’s pricing strategy
Fluctuations in price of raw material
Policy changes
FACTORS AFFECTING RISK
Economic - Domestic & International
Political / Country Risk
Regulatory
Spillover
Other untoward events
IDENTIFYING RISKS
Strong information system for Currency exposure
Continuous flow of information, review of factors affecting risk
Continuous process involving reading, interaction, experience etc.
Prediction extremely difficult
MANAGEMENT’S APPROACH TOWARDS FX-MANAGEMENT
CONSERVATIVE APPROACH
Hedge the exposure as it arises
Yields and costs of transactions are known
Less risk of cash flow destabilization
Less of management time and effort required
Unlikely to yield optimum results
Any opportunity arising in the market cannot be encashed
MODERATE APPROACH
Partial/Selective hedging
Scope for taking advantage of opportunity gains
Helps in averaging out total cost
Management time and effort required
AGGRESSIVE APPROACH
Active trading in currency
Continuous cancellation and rebooking
Aim is to treat treasury as a separate profit center
Active treasury and management efforts must
High Risk :High Reward scenario
Proper evaluation of risk extremely important bearing in mind risk-taking appetite of the company.
INDIFFERENT APPROACH
No conscious decision to manage exposure
No hedging - everything left to chance
Risk of destabilization of cash flows very high
Merit – ZERO investment of time and effort
Worst approach – Highly speculative
EXCHANGE RATE AND OPERATING EXPOSURE
Changes in revenues, costs, cash-flows and profits
Effects competitiveness of the firm, attractiveness of various markets, relative cost of sourcing inputs
Information required on output market structure, competitor’s cost structure, their likely response to exchange rate changes, own cost structure
Participation of personnel across various functions like marketing, purchase, production and finance
TOOLS FOR HEDGING CURRENCY EXPOSURE
FINANCIAL ENGINEERING PRODUCTS – Forwards, Options, Swaps, Futures, FRA’s Exotic structured products etc
INTERNAL HEDGING STRATEGIES
NETTING – receivables/payables can be netted out by matching amount. It reduces the amount of exposure to be covered hence reducing the banking costs
LEADING & LAGGING – shift the timing of exposures by leading or lagging payables or receivables
INVOICING – choice of currency for invoicing
ASSET & LIABILITY MANAGEMENT – for e.g increase exposed cash inflows in stronger currencies and vice-versa
PRICE VARIATION
FINANCIAL ENGINEERING PRODUCTS
Forwards, Futures, Options, Swaps
Some Myths
Complex pricing
Greater loss due to complexities
Difficult to manage
Upfront Premia – Mental Block
Zero Cost Options!! – Is there any free lunch anywhere??
Choosing the right product
Usage depends on market perception and individual requirement.
OPTIONS
A contract between two parties which gives them the right but not the obligation to buy/sell at an agreed price at a future date
Call Option: Right to buy
Put Option: Right to sell
Exercise price: Set price between two parties
Option premium: The price buyer pays to the seller.
Loss potential: Limited to premium.
Downside risks protected, upside gains unlimited.
Profit potential: Limited or unlimited depending on the strategy.
Options are best bet if markets are volatile and risks are asymmetric.
SWAPS
Swap is an agreement between two parties to exchange their liability (Interest, Principal)
Interest rate swap exchange of periodic interest payments (No exchange of principal). Eg. from fixed rate of interest to floating rate and vice versa.
Currency Swap exchange of interest and principal in two different currencies.
USAGE
Asset/Liability management
Issuing or reducing the burden of debt
(Please see our FOREX EDUCATION section for detailed understanding of Derivative Products)
RISK/REWARD
Gain
Loss
Fixed rate payer
Loss
Gain
Floating rate payer
Interest Rate Increases
Interest Rate Decreases
Risk/Reward profile of parties in Interest rate swap
3F’s OF THE FX MARKET
FORWARDS – contract to sell/buy specific amount of currency at a future date against expected receivables/payables at a pre-determined rate
FORWARD RATE AGREEMENT (FRA) This is interest rate agreement for future dates between two parties on LIBOR/LIBID
FUTURES - simultaneous right and obligation to buy/sell a standard quantity of a specific financial instrument at a specified future date and at a price agreed between parties at the time of contract.
FORWARDS & FUTURES
Low commission cost and narrow bid/offer spread on Eurodollar futures. Relatively high commission but narrow bid/offer spread of forex futures.
Low commission bid/offer spread on FRAs. Low commission but variable bid/offer spread on forex forwards.
Equal access regardless of size
Bid/Offer spread may vary with customer
Margin cost involved
Credit approval and lines required
Daily cash settlement
Settlement at maturity
Standardized contracts
Tailored contracts
Exchange traded contracts
OTC contracts
Futures
Forwards
OPERATIONAL STRATEGY
Setting optimum target rate
Protecting benchmark rate
Strong management information system
Minimizing exchange risk
While hedging protect operational profit
Reducing interest burden
Implementing sales policy on cost basis
Minimizing foreign currency loan liability
Trading positions
Safeguard Operating Profit & Target
Stop Loss / Take Profit Limit
Lead & Lag Policy
Continuous In & Out
Options
Review bench rate as per market trend
RECOMMENDING A STRATEGY
Strategy for Current account
Prevailing market conditions
Market perceptions/views
Safeguarding operating profit
Quantify Expectations
Choice of currency, Quantum of cover
Quantify and analyse cost of exposure with projection And actual
Strategy for Capital account
Tenure and costs involved
Currency of Cash flow
Reducing cost of interest
Analyzing debt v/s cost and return
FEATURES OF MIS REPORTS
Streamline information
Quick glance at current position
Tool for day-to-day monitoring
Summary for top management
Strong back office & reporting system
Cost benefit analysis
Clinical precision in interpretation of data
Identifying exchange risk
Monitoring P&L of treasury
Evaluation of performance
ADVANTAGES OF INTEGRATED TREASURY MANAGEMENT
Reduces cost of domestic funds and forex
Competitive cost advantage
Optimum opportunity gains
Asset/Liability management
Easy availability of funds
An edge over others
REGULATORY IMPLICATIONS
Regulatory implications are controlled mainly by four agencies:
MoF: Formulates the policies and directives.
RBI:
ECD: Based on govt. policies, issues instructions and notifications.
IECD: Manages export import credit regulations.
FEDAI:Association of bankers which implements & decides operational procedures on the basis of RBI directions.
Banks & Institutions: Based on overall directives as above under liberalized scenario decides their own policies and guidelines.
SUGGESTIONS & RECOMMENDATIONS
Hedging & Trading positions should be separately identified
Firm decision should be taken on cost base
Long-term & short-term views should be taken separately based on long & short term trend
Need base hedging policy should be adopted, instead of market driven sentiment
Trading & hedging policy should be clearly identified
An approved Forex policy should be formulated
A core committee for periodical review
Set up strong back office and reporting system
Set up treasury as a separate profit center
FOREX RISK MANAGEMENT
OBJECTIVES BEHIND FOREX MANAGEMENT
COST REDUCTION
CONTAIN LOSSES
OPTIMISING EXCHANGE GAIN
PROTECT OPERATING PROFIT
ACHIEVE BUDGETS AND TARGETS
INSURE AGAINST ADVERSE EXCHANGE RATE MOVEMENTS
HOW TO ACHIEVE THESE OBJECTIVES?
Determine the nature of exposure
Evaluate the risks and rewards
Decide targets & strategies to safeguard against currency risk
Formulate policies for day-to-day operations
Strong MIS Reporting system
Periodical review of performance & strategy
Single treasury concept for forex & money market
KEY FACTORS FOR AN EFFECTIVE STRATEGY
Management’s attitude towards risk
Type of exposure – Tenure & Cost
Firm’s willingness to devote the amount and quality of resource to exposure management function
Access to various markets & instruments such as forwards, options, futures etc and there implications
Choice of currency - Dollar / Non- Dollar
Gross or Net Exposure to be managed
NATURE OF RISK
CURRENCY RISK
- Dollar vs. INR - a) Spot b) Forward
- Cross Currency - DUAL Exposure
INTEREST RATE RISK
Domestic & International
OTHER ECONOMIC RISK
Competitor’s pricing strategy
Fluctuations in price of raw material
Policy changes
FACTORS AFFECTING RISK
Economic - Domestic & International
Political / Country Risk
Regulatory
Spillover
Other untoward events
IDENTIFYING RISKS
Strong information system for Currency exposure
Continuous flow of information, review of factors affecting risk
Continuous process involving reading, interaction, experience etc.
Prediction extremely difficult
MANAGEMENT’S APPROACH TOWARDS FX-MANAGEMENT
CONSERVATIVE APPROACH
Hedge the exposure as it arises
Yields and costs of transactions are known
Less risk of cash flow destabilization
Less of management time and effort required
Unlikely to yield optimum results
Any opportunity arising in the market cannot be encashed
MODERATE APPROACH
Partial/Selective hedging
Scope for taking advantage of opportunity gains
Helps in averaging out total cost
Management time and effort required
AGGRESSIVE APPROACH
Active trading in currency
Continuous cancellation and rebooking
Aim is to treat treasury as a separate profit center
Active treasury and management efforts must
High Risk :High Reward scenario
Proper evaluation of risk extremely important bearing in mind risk-taking appetite of the company.
INDIFFERENT APPROACH
No conscious decision to manage exposure
No hedging - everything left to chance
Risk of destabilization of cash flows very high
Merit – ZERO investment of time and effort
Worst approach – Highly speculative
EXCHANGE RATE AND OPERATING EXPOSURE
Changes in revenues, costs, cash-flows and profits
Effects competitiveness of the firm, attractiveness of various markets, relative cost of sourcing inputs
Information required on output market structure, competitor’s cost structure, their likely response to exchange rate changes, own cost structure
Participation of personnel across various functions like marketing, purchase, production and finance
TOOLS FOR HEDGING CURRENCY EXPOSURE
FINANCIAL ENGINEERING PRODUCTS – Forwards, Options, Swaps, Futures, FRA’s Exotic structured products etc
INTERNAL HEDGING STRATEGIES
NETTING – receivables/payables can be netted out by matching amount. It reduces the amount of exposure to be covered hence reducing the banking costs
LEADING & LAGGING – shift the timing of exposures by leading or lagging payables or receivables
INVOICING – choice of currency for invoicing
ASSET & LIABILITY MANAGEMENT – for e.g increase exposed cash inflows in stronger currencies and vice-versa
PRICE VARIATION
FINANCIAL ENGINEERING PRODUCTS
Forwards, Futures, Options, Swaps
Some Myths
Complex pricing
Greater loss due to complexities
Difficult to manage
Upfront Premia – Mental Block
Zero Cost Options!! – Is there any free lunch anywhere??
Choosing the right product
Usage depends on market perception and individual requirement.
OPTIONS
A contract between two parties which gives them the right but not the obligation to buy/sell at an agreed price at a future date
Call Option: Right to buy
Put Option: Right to sell
Exercise price: Set price between two parties
Option premium: The price buyer pays to the seller.
Loss potential: Limited to premium.
Downside risks protected, upside gains unlimited.
Profit potential: Limited or unlimited depending on the strategy.
Options are best bet if markets are volatile and risks are asymmetric.
SWAPS
Swap is an agreement between two parties to exchange their liability (Interest, Principal)
Interest rate swap exchange of periodic interest payments (No exchange of principal). Eg. from fixed rate of interest to floating rate and vice versa.
Currency Swap exchange of interest and principal in two different currencies.
USAGE
Asset/Liability management
Issuing or reducing the burden of debt
(Please see our FOREX EDUCATION section for detailed understanding of Derivative Products)
RISK/REWARD
Gain
Loss
Fixed rate payer
Loss
Gain
Floating rate payer
Interest Rate Increases
Interest Rate Decreases
Risk/Reward profile of parties in Interest rate swap
3F’s OF THE FX MARKET
FORWARDS – contract to sell/buy specific amount of currency at a future date against expected receivables/payables at a pre-determined rate
FORWARD RATE AGREEMENT (FRA) This is interest rate agreement for future dates between two parties on LIBOR/LIBID
FUTURES - simultaneous right and obligation to buy/sell a standard quantity of a specific financial instrument at a specified future date and at a price agreed between parties at the time of contract.
FORWARDS & FUTURES
Low commission cost and narrow bid/offer spread on Eurodollar futures. Relatively high commission but narrow bid/offer spread of forex futures.
Low commission bid/offer spread on FRAs. Low commission but variable bid/offer spread on forex forwards.
Equal access regardless of size
Bid/Offer spread may vary with customer
Margin cost involved
Credit approval and lines required
Daily cash settlement
Settlement at maturity
Standardized contracts
Tailored contracts
Exchange traded contracts
OTC contracts
Futures
Forwards
OPERATIONAL STRATEGY
Setting optimum target rate
Protecting benchmark rate
Strong management information system
Minimizing exchange risk
While hedging protect operational profit
Reducing interest burden
Implementing sales policy on cost basis
Minimizing foreign currency loan liability
Trading positions
Safeguard Operating Profit & Target
Stop Loss / Take Profit Limit
Lead & Lag Policy
Continuous In & Out
Options
Review bench rate as per market trend
RECOMMENDING A STRATEGY
Strategy for Current account
Prevailing market conditions
Market perceptions/views
Safeguarding operating profit
Quantify Expectations
Choice of currency, Quantum of cover
Quantify and analyse cost of exposure with projection And actual
Strategy for Capital account
Tenure and costs involved
Currency of Cash flow
Reducing cost of interest
Analyzing debt v/s cost and return
FEATURES OF MIS REPORTS
Streamline information
Quick glance at current position
Tool for day-to-day monitoring
Summary for top management
Strong back office & reporting system
Cost benefit analysis
Clinical precision in interpretation of data
Identifying exchange risk
Monitoring P&L of treasury
Evaluation of performance
ADVANTAGES OF INTEGRATED TREASURY MANAGEMENT
Reduces cost of domestic funds and forex
Competitive cost advantage
Optimum opportunity gains
Asset/Liability management
Easy availability of funds
An edge over others
REGULATORY IMPLICATIONS
Regulatory implications are controlled mainly by four agencies:
MoF: Formulates the policies and directives.
RBI:
ECD: Based on govt. policies, issues instructions and notifications.
IECD: Manages export import credit regulations.
FEDAI:Association of bankers which implements & decides operational procedures on the basis of RBI directions.
Banks & Institutions: Based on overall directives as above under liberalized scenario decides their own policies and guidelines.
SUGGESTIONS & RECOMMENDATIONS
Hedging & Trading positions should be separately identified
Firm decision should be taken on cost base
Long-term & short-term views should be taken separately based on long & short term trend
Need base hedging policy should be adopted, instead of market driven sentiment
Trading & hedging policy should be clearly identified
An approved Forex policy should be formulated
A core committee for periodical review
Set up strong back office and reporting system
Set up treasury as a separate profit center
