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There are different types of risk involved in foreign exchange. One type of risk is risk...

There are different types of risk involved in foreign exchange. One type of risk is risk involved in forward markets. There are various factors involved in the fluctuation or the rate of forward market. Explain the factors involved in forward market and why should a treasury department hedge or keep the exposure open for a currency (explain with an example).

Solutions

Expert Solution

Below are the five factors of forward markets:

  1. Forward margin: Forward margin depends on the perception of buyer and seller of the currency. It is nothing but a premium on the currency where the forward is costlier than its spot rate and a discount where the forward rate is cheaper then its spot rate. Generally it is quoted for premium or discount based upon the same currency as of the spot rate.
  2. Delivery option: It refers to the process of choosing the value date within an agreed period. In interbank market the date is limited to the extent of calendar month but it can be extended to further date by mutual consent. One feature of the Indian market is that the delivery of a claim for foreign currency receivable is considered as delivery of the foreign currency although the currency may be receivable after some time.
  3. Card rates for customer transactions: The customer transactions are undertaken at a large number of branches to calculate card rates for the transactions in the FX treasury by considering the ruling rates in the domestic and international markets. These card rates are then communicated to the operating branches by telephone or fax or e-mail etc. The card rates are used for undertaking customer transactions for amounts not exceeding a stipulated limit. Generally, these card rates are for relatively small value transactions. For large value transactions which are beyond the stipulated limits, the branches are expected to telephone the FX treasury and get applicable rate. General, these would be more competitive and based on the ruling interbank rates.
  4. Interbank forward quotations: These quotations are made paisa per dollar or any other foreign currency which is applicable to end of the month deliveries. As the interbank market will not be active beyond 12 months. The interbank forward quotations are quotes used & applied for transactions between two banks to ensure to remove the mismatch of maturities in their forward transactions.
  5. Cash spots and call rates: The cash spot margin in the interbank market is governed by the call market in Indian currency. Because arbitrage is possible between borrowings in the call market at a particular rate and sells cash or buy spot dollar swap in the exchange market. Banks would use the cheaper market. Therefore there is a strong correlation between the cash spot margin and the call rate.

There are many reasons why a treasury department do hedging against foreign exchange currency. But these can be mainly elaborated in to three as follows.

  1. The first one is to protect profit margins from erosion due to fluctuations in exchange rates. If your gross margins are less then your requirement to protect gross margins are very high and if your gross margins are high then your requirement will be less. Many businesses will have a timeline for protecting profit margins that match their sales cycle. Some foreign exchange hedging is booked to match underlying contracts. Some are booked to cover a season or project. Otherwise, hedging contracts might be booked on a rolling basis.
  2. The second one is to create stability and predictability in your cash flows against volatility, uncertainty, complexity and ambiguity. Larger corporations, especially those listed or with complex ownership structures, will often have a shareholder directive to maintain stability in earnings. No CFO wants the share price to plunge in line with currency fluctuations. Stability & predictability can play an important role in meeting shareholder expectations.
  3. The other reason is to remain competitive, If your competitors are pricing their product as per average hedge rate then your position will be different in the spot market. Hence it is necessary to compete on the same playing field as your competitors rather than on the foreign exchange market.

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