A Report

On

‘Managing FOREX Exposure‘

Submitted by:

Cijil Diclause

Harshita Periwal

Kuldeep Indeevar

Sandeep Aggarwal

Minu Kumari
Contents
Foreign Exchange Risk...........................................................................................................................3
Types of Exposure.............................................................................................................................3
Translation Exposure.............................................................................................................................3
Transaction Exposure............................................................................................................................4
Economic Exposure...............................................................................................................................5
Hedging Techniques:.............................................................................................................................5
Internal..............................................................................................................................................5
Netting:..................................................................................................................................................5
Leading & Lagging..................................................................................................................................5
Invoicing................................................................................................................................................6
External Hedging strategies...................................................................................................................6
Forwards:...............................................................................................................................................7
Futures:.................................................................................................................................................7
Options:.................................................................................................................................................8
Swaps:...................................................................................................................................................8
Basket Option:.......................................................................................................................................9
Contingent Premium Option:.................................................................................................................9
Chooser Option:..................................................................................................................................10
Compound Option:..............................................................................................................................10
Regular Ratchet Options......................................................................................................................11
Compound Ratchet Options................................................................................................................12
Rainbow Option:..................................................................................................................................12
Barrier options:....................................................................................................................................13
Knock out:............................................................................................................................................14
Knock in:..............................................................................................................................................15
Asian options:......................................................................................................................................16
Average Option:...................................................................................................................................17
Average price/rate option:..................................................................................................................17
Gold Dinar Hedging.............................................................................................................................18
Infosys Technologies Ltd......................................................................................................................20
What followed the aggressive hedging strategy..............................................................................21
Back-2-Back Loan hedging technique for long term hedging...........................................................21
Ranbaxy Laboratories – Forex Hedging...............................................................................................22
Foreign Exchange Risk

Foreign exchange risk is the possibility of a gain or loss to a firm that occurs due to
unanticipated changes in exchange rate. It is linked to unexpected fluctuations in the value of
currencies. A strong currency can very well be risky, while a weak currency may not be
risky. The risk level depends on whether the fluctuations can be predicted. Short and long-
term fluctuations have a direct impact on the profitability and competitiveness of business.
The high volatility of exchange rates is a fact of life faced by any company engaged in
international business. For example, if an Indian firm imports goods and pays in foreign
currency(say dollars), its outflow is in dollars, thus it is exposed to foreign exchange risk. If
the value of the foreign currency rises (i.e., the dollar appreciates), the Indian firm has to pay
more domestic currency to get the required amount of foreign currency.
Typically, a Foreign exchange risks, therefore, pose one of the greatest challenges to a
multinational companies. These risks arise because multinational corporations operate in
multiple currencies. Infact, many times firms who have a diversified portfolio find that the
negative effect of exchange rate changes on one currency are offset by gains in others i.e.
-exchange risk is diversifiable.

Types of Exposure:

Translation Exposure

It is the degree to which a firm’s foreign currency denominated financial statements are
affected by exchange rate changes. All financial statements of a foreign subsidiary have to be
translated into the home currency for the purpose of finalizing the accounts for any given
period. If a firm has subsidiaries in many countries, the fluctuations in exchange rate will
make the assets valuation different in different periods. The changes in asset valuation due to
fluctuations in exchange rate will affect the group’s asset, capital structure ratios, profitability
ratios, solvency rations, etc.
The Company records the gain or loss on effective hedges in the foreign currency fluctuation
reserve until the transactions are complete. On completion, the gain or loss is transferred to
the profit and loss account of that period.

Transaction Exposure

This exposure refers to the extent to which the future value of firms domestic cash flow is
affected by exchange rate fluctuations. It arises from the possibility of incurring foreign
exchange gains or losses on transaction already entered into and denominated in a foreign
currency.
The degree of transaction exposure depends on the extent to which a firm’s transactions are
in foreign currency: For example, the transaction in exposure will be more if the firm has
more transactions in foreign currency. Unlike translation gains and losses which require only
a bookkeeping adjustment, transaction gains and losses are realized as soon as exchange rate
changes. The exposure could be interpreted either from the standpoint of the affiliate or the
parent company. An entity cannot have an exposure in the currency in which its transactions
are measured.
Transaction risk is associated with the change in the exchange rate between the time an
enterprise initiates a transaction and settles it. For Example, an exporter may quote a price of
$10,000 based on exchange rate of Rs.30 per dollar. He hopes to receive Rs.4,80,000 on
executing the order. If the contract is executed after three months, and the exchange rate is
atRs.34 per dollar, the exporter receives only Rs.3,40,000 short of his expectations by Rs. 40,
It is this uncertainty about the amount to be received on conversion that leads to transaction
exposure. The Transaction losses or gain absorbed in the profit and loss account for the year
concerned , and thus affect the profit of the enterprise

Economic Exposure

Economic exposure refers to the degree to which a firm’s present value of future cash flows
can be influenced by exchange rate fluctuations. Economic exposure is a more managerial
concept than an accounting concept. A company can have an economic exposure to say
Pound/Rupee rates even if it does not have any transaction or translation exposure in the
British currency. This situation would arise when the company’s competitors are using
British imports. If the Pound weakens, the company loses its competitiveness (or vice versa if
the Pound becomes strong).Thus, economic exposure to an exchange rate is the risk that a
variation in the rate will affect the company’s competitive position in the market and hence
its profits. Further, economic exposure affects the profitability of the company over a longer
time span than transaction or translation exposure. Under the Indian exchange control,
economic exposure cannot be hedged while both transaction and translation exposure can be
hedged.

Hedging Techniques:

Internal

Netting:
The settlement of obligations between two parties that processes the combined value of
transactions. It is designed to lower the number of transactions required. For example, if
Bank A owed Bank B $100,000, and Bank B owed Bank A $25,000, the value after netting
would be a $75,000transferfrom Bank A to Bank B ($100,000 - $25,000).

Leading & Lagging

It refers to the adjustment of the times of payments that are made in foreign currencies.
Leading is the payment of an obligation before due date while lagging is delaying the
payment of an obligation past due date. The purpose of these techniques is for the company
to take advantage of expected devaluation or revaluation of the appropriate currencies. Lead
and lag payments are particularly useful when forward contracts are not possible.

It is more attractive to use for the payments between associate companies within a group.
Leading and lagging are aggressive foreign exchange management tactics designed to take
the advantage of expected exchange rate changes. Buckley (1988) supports the argument with
the following example:
Subsidiary b in B country owes money to subsidiary a in country A with payment due in
three months’ time and with the debt denominated in US dollar. On the other side, country
B’s currency is expected to devalue within three months against US dollar moreover vis-à-
vis country A’s currency. Under these circumstances, if company b leads -pays early - it will
have to part with less of country B’s currency to buy US dollar to make payment to company
A. Therefore, lead is attractive for the company. When we take reverse the example-
revaluation expectation, it could be attractive for the lagging.

On the other hand, in case of lagging payment to an independent third party, there is always
the possibility of upsetting the trading relationship, with possible loss of credit facilities or
having prices increased to compensate for the delay in the receipt of funds. There is also the
possibility of damage to the lagging company’s external credit rating.

Invoicing

A firm may able to shift the entire exchange risk to the other party by invoicing its exports in
home currency. Thus hedging against FOREX risk.

External Hedging strategies

 Forward exchange contract for currencies

 Currency future contracts
 Money Market Operations for currencies
 Forward Exchange Contract for interest (FRA)
 Money Market Operations for interest
 Future contracts for interest
Forwards:

A forward is a made-to-measure agreement between two parties to buy/sell a specified

amount of a currency at a specified rate on a particular date in the future. The depreciation of
the receivable currency is hedged against by selling a currency forward. If the risk is that of a
currency appreciation (if the firm has to buy that currency in future say for import), it can
hedge by buying the currency forward. E.g if RIL wants to buy crude oil in US dollars six
months hence, it can enter into a forward contract to pay INR and buy USD and lock in a
fixed exchange rate for INR-USD to be paid after 6 months regardless of the actual INR-
Dollar rate at the time. In this example the downside is an appreciation of Dollar which is
protected by a fixed forward contract. The main advantage of a forward is that it can be
tailored to the specific needs of the firm and an exact hedge can be obtained. On the
downside, these contracts are not marketable, they can’t be sold to another party when they
are no longer required and are binding.

Futures:

A futures contract is similar to the forward contract but is more liquid because it is traded in
an organized exchange i.e. the futures market. Depreciation of a currency can be hedged by
selling futures and appreciation can be hedged by buying futures. Advantages of futures are
that there is a central market for futures which eliminates the problem of double Forecasts
Risk Estimation Benchmarking Hedging Stop Loss Reporting and review coincidence.
Futures require a small initial outlay (a proportion of the value of the future) with which
significant amounts of money can be gained or lost with the actual forwards price
fluctuations. This provides a sort of leverage. The previous example for a forward contract
for RIL applies here also just that RIL will have to go to a USD futures exchange to purchase
standardised dollar futures equal to the amount to be hedged as the risk is that of appreciation
of the dollar. As mentioned earlier, the tailorability of the futures contract is limited i.e. only
standard denominations of money can be bought instead of the exact amounts that are bought
in forward contracts.
Options:

A currency Option is a contract giving the right, not the obligation, to buy or sell a specific
quantity of one foreign currency in exchange for another at a fixed price; called the Exercise
Price or Strike Price. The fixed nature of the exercise price reduces the uncertainty of
exchange rate changes and limits the losses of open currency positions. Options are
particularly suited as a hedging tool for contingent cash flows, as is the case in bidding
processes. Call Options are used if the risk is an upward trend in price (of the currency),
while Put Options are used if the risk is a downward trend. Again taking the example of RIL
which needs to purchase crude oil in USD in 6 months, if RIL buys a Call option (as the risk
is an upward trend in dollar rate), i.e. the right to buy a specified amount of dollars at a fixed
rate on a specified date, there are two scenarios. If the exchange rate movement is favourable
i.e the dollar depreciates, then RIL can buy them at the spot rate as they have become
cheaper. In the other case, if the dollar appreciates compared to today’s spot rate, RIL can
exercise the option to purchase it at the agreed strike price. In either case RIL benefits by
paying the lower price to purchase the dollar.

Swaps:

A swap is a foreign currency contract whereby the buyer and seller exchange equal initial
principal amounts of two different currencies at the spot rate. The buyer and seller exchange
fixed or floating rate interest payments in their respective swapped currencies over the term
of the contract. At maturity, the principal amount is effectively re-swapped at a
predetermined exchange rate so that the parties end up with their original currencies. The
advantages of swaps are that firms with limited appetite for exchange rate risk may move to a
partially or completely hedged position through the mechanism of foreign currency swaps,
while leaving the underlying borrowing intact. Apart from covering the exchange rate risk,
swaps also allow firms to hedge the floating interest rate risk. Consider an export oriented
company that has entered into a swap for a notional principal of USD 1 mn at an exchange
rate of 42/dollar. The company pays US 6months LIBOR to the bank and receives 11.00%
p.a. every 6 months on 1st January & 1st July, till 5 years. Such a company would have
earnings in Dollars and can use the same to pay interest for this kind of borrowing (in dollars
rather than in Rupee) thus hedging its exposures.

Basket Option:
A basket option is an option with an underlying asset "basket" of securities, currencies or
commodities. Basket options are a popular way to hedge portfolio risk. Meanwhile, using the
basket option costs significantly less than buying an option on the individual components of
the portfolio.

A currency basket option provides a cheaper method for multinational corporations to

receive/sell a basket of several currencies for one specified currency. An example would be
MacDonald's buying a basket option involving Indian rupees and British pounds in exchange
for U.S. dollars.

Basket options often are used as a cost-effective way for portfolio managers to consolidate
multicurrency exposures. This works because a basket option offers the unique
characteristic of a strike price based on the weighted value of the basket of currencies,
calculated in the buyer's base currency. The buyer chooses the maturity of the option, the
foreign currency amounts for the basket and the aforementioned strike price.

Basket options are often priced by treating the basket's value as a single underlier and
applying standard option pricing formulas. An error is introduced by the fact that a weighted
sum of lognormal random variables in not lognormal, but this is generally modest.

Contingent Premium Option:

A contingent premium option is basically a European option. The premium will be paid if the
contingent premium option finishes "in the money". Otherwise, if the option expires "at the
money" then, no premium will be paid.

"In the money" is a financial term used to refer an option whose value depends on the present
market price, that is, whether the market price exceeds the call price of the option or not. On
the other hand, "at the money" means the market price of the option and the strike price is
equal. 

If a contingent premium option expires "in the money" then there is a possibility of loss, that
is, the expiration value, market value at the time of expiration of the option is very important.
However, the buyer of the contingent premium option usually pays no "upfront premium"
but, promises to pay a Premium, which is predetermined, if the option has any expiration
value.

Chooser Option:
Chooser Option refers to an option, which can be purchased by paying up-front premium.

This Chooser Option is a path dependent option. This means that, the terminal value of
Chooser Option depends on the value of the underlier. This dependence remains present at all
prior points of time.

So, in this way, over the life of the option, the terminal value of Chooser Option depends on
the path of the underlier.

In case of Chooser Option, the person can choose the derivative as a vanilla put option or call
option. But, the person is required to make the choice in a fixed period of time. It is very
obvious that, the chooser feature of the Chooser Option, increasingly gains value with longer
choice period. 

In Chooser Option, whatever is the alternative chosen by the person, call or put, each of them
are generally associated with a single expiration date. In the similar way, both the alternatives
usually carry a single strike price. 

Compound Option:
Compound Option can be best described as an option on an option. Generally, Compound
Option comes in four basic forms. These basic forms are called put on a put, put on a call,
call on a call and call on a put.

 All these basic forms of Compound Options are associated with two expiration dates and two
strike prices. Between the two expiration dates, one is tagged with Compound Option and the
other is tagged with underlying option. Similarly, among the two strike prices, one is fixed
for Compound Option and another one is associated with the underlying option. 

Compound Option carries two types of option premiums. One serves as the paid up front for
the compound option. Another option premium is paid for the underlying option, in the event
of exercising the compound option. 

In case of exercising the Compound Option, the total amount of the combined premiums,
may exceed the level of premium that is required for buying the underlying option at the very
start. The value of the Compound Option is very volatile.

The Compound Options carry with them Vanilla Options. These vanilla options offer an
advantage by allowing the option to be extended. In this case, the option can be extended
beyond the expiration date. For, this reason, these are also called Extendible Options.

The advantages of compound options are that they allow for large leverage and they are
cheaper than straight options. However, if both options are exercised, the total premium will
be more than the premium on a single option.

Ratchet Option:
A ratchet option (also called a reset option or cliquet option) is a series of consecutive
forward start options. The first is active immediately. The second becomes active when the
first expires, etc. Each option is struck at-the-money when it becomes active. The effect of
the entire instrument is of an option that periodically "locks in" profits in a manner somewhat
analogues to a mechanical ratchet. Ratchet features can be incorporated into other structures.

A cliquet or ratchet option is a series of at the money options, with periodic settlement,
resetting the strike value at the then current price level, at which time, the option locks in the
difference between the old and new strike and pays that out as the profit. The profit can be
accumulated until final maturity, or paid out at each reset date.

Regular Ratchet Options

The regular ratchet option is simply the cliquet / ratchet option.

Compound Ratchet Options

Compound ratchet options are similar to standard ratchet options, with the exception that
each return gained at reset dates is carried forward, increasing the notional value. No payouts
are made at each reset date and the accumulated amount is given only at maturity.
 Rainbow Option:

Rainbow option may be referred to an option, which is connected to more than two or two
underlying assets. However, it is obligatory that if the option has to payoff, the underlying
assets (all of them) be required to move in similar directions. The underlying assets may
differ from one another in various aspects like:

 Strike price
 Features
 Expiry dates

An example will help in making the concept of rainbow option clear. For instance, a soccer
match is to be held at a venue, there are four soccer fields at close proximity. In one field, a
soccer match is about to end, in another field the soccer match is going on, in the third field
the soccer match is scheduled to start within an hour or two and in the last field soccer match
just started. If an investor bets on the winners of all the three matches, he is benefited but if
any one of the matches is lost, the investor gets nothing at all. 

Some standard forms of rainbow options are:

A maximum option is a bundle of vanilla options with a variety of features different strikes,

different underliers, some may be puts, others calls, but they generally have the
same expiration date. Only one of these may be exercised, and this is chosen in the holder's
favour at expiration.

A minimum option is a bundle of vanilla options like a maximum option. Only one of the
options can be exercised, and this is chosen in the issuer's favour at expiration.

A better-of option is a bundle of long forwards. All mature on the options expiration date
but have different underliers. At expiration, only one settles, and this is chosen in the holder's
favour.

A worst-of option is a bundle of long forwards. All mature on the options expiration date but
have different underliers. At expiration, only one settles, and this is chosen in the issuer's
favour.
A two-asset correlation option is linked to two underliers. It pays off like a vanilla option
on one underlier if the expiration value of the other underlier is in a specified range. The
vanilla option can be either a put or a call.

Together, maximum options and minimum options are referred to as min-max options.
Better-of or worst-of options are referred to collectively as alternative options

Features of Rainbow Option:

In the event when two assets are extremely correlated, options on the assets are not so
expensive. On the contrary, if the assets are not so much correlated, options on them become
comparatively expensive. As a rule, if assets have less correlation, there is more variability.

Advantage of Rainbow Option:

Rainbow options may be used as instruments for hedging uncertainties pertaining to multiple
assets.

Barrier options:
Barrier options belong to the category of exotic options – extremely popular among forex
option traders – meaning that they possess a component other than the expiry date and the
strike price. Regarding barrier options, the additional component is the trigger – or the barrier
– which if reached either brings the option into being (knock in option) or cancels it (knock
out option). You thus choose a strike price as well as a trigger. Since there is a chance that
these options may never come into effect or may be cancelled, they are generally cheaper that
their vanilla counterpart. Exotic options also include binary options which are based on a
hypothetical scenario where you decide how much profit you want to make if the rate reaches
a certain level.

There are single barrier options and double barrier options. A double barrier option has
barriers on either side of the strike. A single barrier option has one barrier that may be either
greater than or less than the strike price. Why would we ever buy an option with a barrier on
it? Because it is cheaper than buying the plain vanilla option and we have a specific view
about the path that spot will take over the lifetime of the structure.
Barrier options-is of four types:

There are 4 types of Barrier Option features:

Up-and-In: Underlying asset needs to move up and beyond barrier price for the barrier
option to become active.

Up-and-Out: Barrier option becomes de-activated if the underlying asset moves up beyond
the barrier price.

Down-and-In: Underlying asset needs to move down and beyond barrier price for the barrier
option to become active.

Down-and-Out: Barrier option becomes de-activated if the underlying asset moves down
beyond the barrier price.

Knock out:
The knock out option will automatically cease to exist and expire worthless (it will be
"knocked out”) if and when the trigger price is reached before the expiration date. If the rate
never hits the barrier, the knock out option runs the same way as a regular option. For a call
knock-out option, the trigger is set below the spot rate, and above for a put (out-of-the-
money). The higher the implied volatility, the greater the chance the barrier being triggered
and the option being knocked out. Knock-out options are cheaper than regular put or call
option (vanilla) since they may be knocked out before expiry. The premium gets cheaper as
the barrier gets closer to the spot rate since the option has a greater chance of being knocked
out.

Advantage:

1. Cheaper, resulting in higher profits.

2. Ideal for speculating small moves.

Disadvantage:

1. Higher risk of loss if underlying asset rallies.

2. Commonly traded for forex, not stocks.

Example:

A European exporter with US15 million in receivables buys a 3 month 0.9700 EUR
Call/USD Put with a KO at 0.9050 for 0.70% EUR (a simple option without the KO feature
costs 0.97% EUR). (Spot Reference: 0.9250)

If 0.9050 never trades during the life of the option, and:

· Spot on expiration is above 0.9700, the exporter sells USD and buys EUR at 0.9700
· Spot on expiration is below 0.9700, the exporter sells USD and buys EUR at the prevailing
spot rate.

If 0.9050 trades at any time during the life of the option, then the option is terminated and the
exporter can sell EUR and buy USD to the end date and achieve a more favorable forward
rate than originally available.

Knock in:
A knock-in option becomes a regular option (it is "knocked in”) if and when the trigger price
is met before the expiration date. This means that if the rate is never reached, the contract is
cancelled and the buyer loses the premium. If the barrier rate is met, then the option starts
running like a regular put or call option. Knock-in options are less expensive than regular
options since they have an additional conditional component that cheapens the price of the
premium. The further the barrier to the spot rate, the cheaper the premium, since there is a
lesser chance that the option will be knocked in before the expiration date.

Advantages:

1. Cheaper, resulting in higher profits

2. Ideal for speculating huge moves
Disadvantage:

1. Higher risk of loss if underlying asset moves moderately.

2. Commonly traded for forex, not stocks.

e.g.

The same customer has a bullish view on the EUR/USD. He feels there is a possibility it
could weaken in the near-term. To express this view and to lower the premium cost, the
customer buys a 3 month 0.9400 EUR Call/USD Put with a KI at 0.8900 for 1.2% EUR
(compared to buying the simple option at 1.96% USD). (Spot Reference: 0.9250). If 0.8900
never trades during the life of the KI option, then no option is created and the contract expires
worthless. If 0.8900 trades, then the customer becomes long a 0.9400 EUR Call USD Put and
can manage the position accordingly based on his view.

Asian options:

David Spaughton and Mark Standish invented this method of pricing options. They belonged
to Tokyo, Japan, that's why the option is named as Asian option. It is available at a low cost,
for which, the exporters like this. An Asian option, also known as Average Option, is a kind
of option whose payoff has a strong linkage with the underlier's average value through a
specific period during the entire option life. The tag Asian does not carry any special
meaning. The two founders of Asian option, David Spaughton and Mark Standish, first
invented the pricing formula for option trading. Since they belonged to Asia, the method is
named as Asian Option. The average can be calculated both arithmetically and geometrically.
It can be weighted as well with some specific weights. However, exact formula for the Asian
option does not exist, for the arithmetic mean of a set of "lognormal random variables" has a
highly intractable distribution.
Average Option:
 

A plain vanilla option pays out the difference between its predetermined strike price and the
spot rate of the underlying at the time of expiry. The purchaser of an average, on the other
hand, will receive a pay-out which depends on the average value of the underlying. The
average can be calculated in a number of ways from the spot rate on a predetermined series of
dates. An average rate option is a cash-settled option with a predetermined strike which is
exercised at expiry against the average value of the underlying over the specified dates. In
general, hedging with an average option is cheaper than using a portfolio of vanilla options,
since the averaging process offsets high values with low ones and therefore lowers volatility
and premium.

Average options, also known as Asian options, are particularly popular in the equity,
currency and commodity markets. In contrast, the strike for an average strike option is not
fixed until the end of the averaging period which is typically much before the expiry. When
the strike is set, the option is exercised against the prevailing spot rate. Unlike average price
options, average strike options may be either cash or physically settled. In the case of an
average hybrid option, both the strike and settlement price of the option are determined using
the average, where the strike averaging period typically precedes the settlement price
averaging period. For the average ratio option, both the strike and settlement price of the
option are determined using the average as in the hybrid case. The final payout is determined
by comparing the ratio of settlement price to strike and a fixed percent strike.

Average price/rate option:

An option whose settlement value is based on the difference between the strike and the
average price (rate) of the underlying on selected dates over the life of the option, or over a
period beginning on some start date and ending at expiration. The theoretical value of an
average price or rate call will usually be less than the value of an otherwise identical standard
option because the average price option acts like an option with a shorter expected life. The
premium on an average price or rate option also will tend to be less than the combined
premiums of a strip of options expiring on each measurement date, because prices or rates on
the wrong side of the strike will reduce the average price or rate and, hence, the expected
settlement value of the option. With a strip, observations on the wrong side of the strike
would make one piece of the strip worthless but would not drag down the value of the others.

Gold Dinar Hedging

In this mode, the central bank would play an important role of keeping national trade
accounts and a place to safe-keep gold. When India trades with China for example, the gold
accounting is kept through the medium of central bank and only the net difference between
the two is settled periodically. Hence every transaction in essence involves gold movement.
However since bilateral and multilateral trades are ongoing processes, any gold that needs to
be settled can always be brought forward and used for future transactions and settlements. On
the ground, commercial banks that support gold accounts seem a viable partner in the
implementation of the gold dinar. International trade participants - individuals, businessmen,
corporations and traders - would deal with commercial banks that provide such gold
accounts. These commercial banks would in turn deal with the central bank for their
respective gold accounts.
As an example, consider that India exports 100 bullion gold worth of goods and services to
China while importing 80 bullion worth of goods and services. Hence India has a surplus
trade of 20 bullion. China needs to settle only this difference of 20 bullion. However, this
amount could be used for settling future trade imbalances between the countries and hence a
physical gold movement between the countries is not necessary. This simple structure
completely eliminates exchange rate risk. Even though international gold price may fluctuate,
the participants realize that they have something that has intrinsic value that can be used for
stable and continuous trade into the future. Therefore, even though with the existence of other
national currencies, speculation and arbitrage on gold price could tempt a participating
country to redeem or sell its gold, it should resist such temptation for the sake stability of
future trades. At this juncture, one may ask the question, how does this structure differ from a
simple barter trade between the countries? The advantage is that gold acts as unit of account
and this eliminates problems associated with barter.

This simple gold payment system has numerous advantages:

1. Foreign exchange risk is totally eliminated. This means there is no need for forward,
futures or options on the currencies of the participating countries. Here the hedging cost is
fixed against gold, but note that even if hedging is done to fix the cash flow in any currency
there is still risk in the fluctuation of that currency. Gold is superior here because it has
intrinsic value.

2. Reduced currency speculation and arbitrage between the currencies. For example, if three
countries agree to use the gold payment system, then it is akin that the three currencies
become a single currency. Then speculation and arbitrage among these three currencies will
be very much reduced. This unification of the three currencies through the gold dinar
provides diversification benefits. It is like obtaining diversification through a portfolio of
stocks. Individual currencies face risks that are unique to the issuer country. For example a
political turmoil can cause a national currency to depreciate. But in a unified currency such
unique risks would be diversified away. In fact, since people of all race, creed and nationality
treasure gold, gold is a global currency that enjoys global diversification. This means no
single country’s unique risk may be significantly embedded in gold.

3. Low transaction costs since only accounting records need to be kept. Transactions can be
executed by means of electronic medium for which some commissions are charged. The cost
of such electronic transactions is generally low. Hence for international trades in this system,
one no longer needs to open a Letter of Credit (LC) with a bank, incur exchange rate
transaction costs or even face exchange rate risk.

4. The gold dinar reduces the need to create a significant amount of national currencies
through the banking sector. This therefore highly reduces the possibility of future attacks on
the Ringgit like the one in 1997.

5. Since the gold accounts are kept internally through commercial banks and central bank,
transactions costs would not incur a gold outflow from the country.
Infosys Technologies Ltd.

Infosys revenue in dollar terms grew by 35% in 2008, while it grew just by 19% in INR
(functional currency of Infosys). Infosys notionally lost around Rs.2000 crores in revenue and
Rs. 1000 crores in net profit.
Infosys received 98.4% of its revenues from export, making it very much vulnerable to
fluctuations in foreign exchange rates. The table below list the revenues from different
geographies.

Geography Percentage Share in Revenues

North America 63.1%
Europe 26.9%
Rest of World 8.6%

Infosys hedges its foreign currency risk in different currencies as different currencies do not
appreciate/depreciate similarly. For ex while US Dollar appreciated 11.2% against INR,U.K
Pound appreciated only 6.4% and Euro appreciated just 1.8%
Infosys uses forwards and options (including exotic options) to hedge its currency risk.
Infosys outstanding options & forward contracts as on 31 March 2008 are as following:
Hedging trends for Infosys:

2008 % 2007 % 2006 %

Forward Contract 2148 81% 723 40% 445 32%

Option Contract
Range Barrier 400 15% 884 49% 934 67%
Euro Accelerator 76 3% 138 8% 16 1%
Euro Forward 23 1% 47 3%
Total 2656 1792 1395

What followed the aggressive hedging strategy

Non-operating income was impacted due to rupee depreciation, cross-currency fluctuation

and lower utilisation rate. Though operating margin increased by two percent to 35.1 percent
in the third quarter from 33.1 percent in the second quarter. The net impact was 2.3 percent
due to hedging at higher rupee and translation loss. A depreciating rupee had forced Infosys
to reduce its exposure to hedging in the currency market to $576 million from $932 million
for the next two quarters. Infosys started to hedge short term.

Back-2-Back Loan hedging technique for long term hedging.

If Infosys wants to buy into a project in US that will repay the investment and earnings in
Dollars over the next N years. . If it can identify an US company that wants to make a
similarly sized investment in the India, it can arrange offsetting loan. Under this arrangement,
the companies are entering into a purely bilateral arrangement outside the scope of the
foreign exchange markets. Neither company is affected by exchange rate fluctuations.

Nevertheless, both companies remain exposed to default risk because the obligation of one
company is not avoided by the failure of the other company to repay its loan.
Ranbaxy Laboratories – Forex Hedging
Ranbaxy Laboratories, India’s largest drugmaker by sales, may be sitting on mark-to-market
(MTM) losses of over Rs 2,500 crore on foreign currency derivatives transactions entered
into with various banks, according to estimates by one of its lenders in February this year. 

With this lender alone, the company is running an MTM loss of Rs 600 crore on the
derivatives contracts it had signed in April-May 2008.However, Ranbaxy is not the only
company that has been hit by forex derivatives losses. The losses have cut across sectors.
According to rating agency Fitch, India Inc’s estimated MTM losses on forex derivatives
transactions are in the range of $4-5 billion.  Within the pharma sector, other companies such
as Wockhardt, Orchid Chemicals, Cipla, Biocon and Jubilant Organosys have suffered
extraordinary losses either in the form of translation losses on their foreign borrowings,
hedging losses or MTM losses on foreign currency convertible bond (FCCB) issuances. 

the drugmaker entered signed “forex options strips” contracts with the foreign bank for
hedging its dollar receivables from exports for a period of eight years. A strip is like a series
of options maturing on certain dates over a period of time, usually with a specified frequency.
These contracts have to be settled on a monthly basis and monthly settlements with the bank
started in June 2008. When these deals were struck, the dollar/rupee exchange rate was at Rs
39.90. Ranbaxy’s forex dealers took a view that the rupee would appreciate further against
the dollar and hedged its dollar receivables at an exchange rate of Rs 43.50 to the dollar at a
leverage of 1:2.5. The contract stipulates that Ranbaxy delivers $1 million (out of its exports)
at Rs 43.50 if the exchange rate is below Rs 43.50. Therefore, even if the dollar is trading at
Rs 39, the drugmaker would collect Rs 43.50 for every dollar. But the flip side is that if the
dollar exceeds Rs 43.50, Ranbaxy delivers $2.5 million every month for a period of eight
years at Rs 43.50. With the dollar quoting at Rs 50 currently, the leverage clause has been
triggered, resulting in a huge MTM loss for the company. It is not unusual for exporters to
enter into options contracts to manage exchange rate risk. In a simple options contract, an
exporter who expects the dollar to fall against the rupee buys an option from a bank by
paying a small premium. The option allows the exporter to sell its dollar receivables at a pre-
determined rupee price.  In case the dollar rises, all that the exporter loses is the premium
paid for buying the option, which is set off by the gain that the exporter will make due to the
dollar’s rise against the rupee, because the exporter can earn more rupees for every dollar it
sells in the market. 
Complications on these deals arise, when exporters start selling options to banks. In this case,
Ranbaxy bought “put options”, the right to “sell” dollars to the bank at a pre-determined
exchange rate, and sold “call options” to the bank, giving the bank a right to “buy” dollars
from Ranbaxy at a pre-determined exchange rate. Since the dollar has risen, contrary to what
Ranbaxy expected, the bank is now exercising the “call options” at Ranbaxy’s peril, resulting
in losses. Ranbaxy declared a loss on fair valuation of derivatives of Rs 784 crore in its
results for the September-December quarter of 2008.

References:

http://www.thaindian.com/newsportal/uncategorized/depreciating-rupee-forces-infosys-to-
slash-hedging-amount_100141903.html#ixzz0yCWMb43W

http://www.businessinsider.com/malaysia-introduces-new-alternate-islamic-currency-gold-
2010-8#ixzz0y8hJedvb

http://www.ebooksx.com/Managing-Currency-Risk-Using-Financial-Derivatives_219731.html