RISK MANAGEMENT IN FOREX MARKET

INTRODUCTION

The Foreign Exchange market, also referred to as the "Forex" or "FX" market is the
largest financial market in the world, with a daily average turnover of US$1.9 trillion — 30
times larger than the combined volume of all U.S. equity markets. "Foreign Exchange" is the
simultaneous buying of one currency and selling of another. Currencies are traded in pairs,
for example Euro/US Dollar (EUR/USD) or US Dollar/Japanese Yen (USD/JPY).

There are two reasons to buy and sell currencies. About 5% of daily turnover is from
companies and governments that buy or sell products and services in a foreign country or
must convert profits made in foreign currencies into their domestic currency. The other 95%
is trading for profit, or speculation.

For speculators, the best trading opportunities are with the most commonly traded (and
therefore most liquid) currencies, called "the Majors." Today, more than 85% of all daily
transactions involve trading of the Majors, which include the US Dollar, Japanese Yen, Euro,
British Pound, Swiss Franc, Canadian Dollar and Australian Dollar.

A true 24-hour market, Forex trading begins each day in Sydney, and moves around the globe
as the business day begins in each financial center, first to Tokyo, London, and New York.
Unlike any other financial market, investors can respond to currency fluctuations caused by
economic, social and political events at the time they occur - day or night.

The FX market is considered an Over the Counter (OTC) or 'interbank' market, due to the fact
that transactions are conducted between two counterparts over the telephone or via an
electronic network. Trading is not centralized on an exchange, as with the stock and futures
markets.
ADVANTAGES OF FOREX MARKET

Although the forex market is by far the largest and most liquid in the world, day
traders have up to now focus on seeking profits in mainly stock and futures markets. This is
mainly due to the restrictive nature of bank-offered forex trading services. Advanced
Currency Markets (ACM) offers both online and traditional phone forex-trading services to
the small investor with minimum account opening values starting at 5000 USD.

There are many advantages to trading spot foreign exchange as opposed to trading stocks and
futures. Below are listed those main advantages.

 Commissions:

ACM offers foreign exchange trading commission free. This is in sharp contrast to (once
again) what stock and futures brokers offer. A stock trade can cost anywhere between USD 5
and 30 per trade with online brokers and typically up to USD 150 with full service brokers.
Futures brokers can charge commissions anywhere between USD 10 and 30 on a round turn
basis.

 Margins requirements:

ACM offers a foreign exchange trading with a 1% margin. In layman's terms that means a
trader can control a position of a value of USD 1'000'000 with a mere USD 10'000 in his
account. By comparison, futures margins are not only constantly changing but are also often
quite sizeable. Stocks are generally traded on a non-margined basis and when they are, it can
be as restrictive as 50% or so.
 24 hour market:

Foreign exchange market trading occurs over a 24 hour period picking up in Asia around
24:00 CET Sunday evening and coming to an end in the United States on Friday around
23:00 CET. Although ECNs (electronic communications networks) exist for stock markets
and futures markets (like Globex) that supply after hours trading, liquidity is often low and
prices offered can often be uncompetitive.

 No Limit up / limit down:

Futures markets contain certain constraints that limit the number and type of transactions
a trader can make under certain price conditions. When the price of a certain currency rises or
falls beyond a certain pre-determined daily level traders are restricted from initiating new
positions and are limited only to liquidating existing positions if they so desire.This
mechanism is meant to control daily price volatility but in effect since the futures currency
market follows the spot market anyway, the following day the futures market may undergo
what is called a 'gap' or in other words the futures price will re-adjust to the spot price the
next day. In the OTC market no such trading constraints exist permitting the trader to truly
implement his trading strategy to the fullest extent. Since a trader can protect his position
from large unexpected price movements with stop-loss orders the high volatility in the spot
market can be fully controlled.

 Sell before you buy:

Equity brokers offer very restrictive short-selling margin requirements to customers. This
means that a customer does not possess the liquidity to be able to sell stock before he buys it.
Margin wise, a trader has exactly the same capacity when initiating a selling or buying
position in the spot market. In spot trading when you're selling one currency, you're
necessarily buying another.
THE ORGANISATION & STRUCTURE OF FOREX IS GIVEN IN THE FIG
BELOW

FOREIGN EXCHANGE RISK

Any business is open to risks from movements in competitors' prices, raw material
prices, competitors' cost of capital, foreign exchange rates and interest rates, all of which
need to be (ideally) managed.

This section addresses the task of managing exposure to Foreign Exchange movements.
These Risk Management Guidelines are primarily an enunciation of some good and prudent
practices in exposure management. They have to be understood, and slowly internalised and
customised so that they yield positive benefits to the company over time.

It is imperative and advisable for the Apex Management to both be aware of these practices
and approve them as a policy. Once that is done, it becomes easier for the Exposure
Managers to get along efficiently with their task.

MANAGING FOREIGN EXCHANGE RISK

Once we have a clear idea of what our foreign exchange exposure will be and the currencies
involved, we will be in a position to consider how best to manage the risk. The options
available to us fall into three categories:

1. DO NOTHING:

We might choose not to actively manage our risk, which means dealing in the spot market
whenever the cash flow requirement arises. This is a very high-risk and speculative strategy,
as we will never know the rate at which we will deal until the day and time the transaction
takes place. Foreign exchange rates are notoriously volatile and movements make the
difference between making a profit or a loss. It is impossible to properly budget and plan our
business if we are relying on buying or selling our currency in the spot market.

2. TAKE OUT A FORWARD FOREIGN EXCHANGE CONTRACT:

As soon as we know that a foreign exchange risk will occur, we could decide to book a
forward foreign exchange contract with our bank. This will enable us to fix the exchange rate
immediately to give us the certainty of knowing exactly how much that foreign currency will
cost or how much we will receive at the time of settlement whenever this is due to occur. As
a result, we can budget with complete confidence. However, we will not be able to benefit if
the exchange rate then moves in our favour as we will have entered into a binding contract
which we are obliged to fulfil. we will also need to agree a credit facility with our bank for us
to enter into this kind of transaction
3. USE CURRENCY OPTIONS:

A currency option will protect us against adverse exchange rate movements in the same way
as a forward contract does, but it will also allow the potential for gains should the market
move in our favour. For this reason, a currency option is often described as a forward contract
that we can rip up and walk away from if we don't need it. Many banks offer currency options
which will give us protection and flexibility, but this type of product will always involve a
premium of some sort. The premium involved might be a cash amount or it could be factored
into the pricing of the transaction. Finally, we may consider opening a Foreign Currency
Account if we regularly trade in a particular currency and have both revenues and expenses in
that currency as this will negate to need to exchange the currency in the first place. The
method we decide to use to protect our business from foreign exchange risk will depend on
what is right for us but we will probably decide to use a combination of all three methods to
give us maximum protection and flexibility.

HEDGING FOREX

If we are new to forex, before focusing on currency hedging strategy, they suggest we first
check out our forex for beginners to help give us a better understanding of how the forex
market works.

A foreign currency hedge is placed when a trader enters the forex market with the specific
intent of protecting existing or anticipated physical market exposure from an adverse move in
foreign currency rates.  Both hedgers and speculators can benefit by knowing how to properly
utilize a foreign currency hedge.  For example: if you are an international company with
exposure to fluctuating foreign exchange rate risk, you can place a currency hedge (as
protection) against potential adverse moves in the forex market that could decrease the value
of your holdings.  Speculators can hedge existing forex positions against adverse price moves
by utilizing combination forex spot and forex options trading strategies.

Significant changes in the international economic and political landscape have led to
uncertainty regarding the direction of currency rates.  This uncertainty leads to volatility and
the need for an effective vehicle to hedge the risk of adverse foreign exchange price or
interest rate changes while, at the same time, effectively ensuring our future financial
position.

Currency hedging is not just a simple risk management strategy, it is a process.  A

number of variables must be analyzed and factored in before a proper currency hedging
strategy can be implemented.  Learning how to place a foreign exchange hedge is essential to
managing foreign exchange rate risk and the professionals at CFOS/FX can assist in the
implementation of currency hedging programs and forex trading strategies for both individual
and commercial forex traders and forex hedgers.  For more hedging information, please click
on the links below.

HOW TO HEDGE FOREIGN CURRENCY RISK

As has been stated already, the foreign currency hedging needs of banks, commercials
and retail forex traders can differ greatly.  Each has specific foreign currency hedging needs
in order to properly manage specific risks associated with foreign currency rate risk and
interest rate risk.

Regardless of the differences between their specific foreign currency hedging needs,
the following outline can be utilized by virtually all individuals and entities who have foreign
currency risk exposure.  Before developing and implementing a foreign currency hedging
strategy, we strongly suggest individuals and entities first perform a foreign currency risk
management assessment to ensure that placing a foreign currency hedge is, in fact, the
appropriate risk management tool that should be utilized for hedging fx risk exposure.  Once
a foreign currency risk management assessment has been performed and it has been
determined that placing a foreign currency hedge is the appropriate action to take, you can
follow the guidelines below to help show you how to hedge forex risk and develop and
implement a foreign currency hedging strategy.

A.  Risk Analysis:  Once it has been determined that a foreign currency hedge is the proper
course of action to hedge foreign currency risk exposure, one must first identify a few basic
elements that are the basis for a foreign currency hedging strategy.
 1. Identify Type(s) of Risk Exposure.  Again, the types of foreign currency risk
exposure will vary from entity to entity.  The following items should be taken into
consideration and analyzed for the purpose of risk exposure management: (a) both
real and projected foreign currency cash flows, (b) both floating and fixed foreign
interest rate receipts and payments, and (c) both real and projected hedging costs (that
may already exist).  The aforementioned items should be analyzed for the purpose of
identifying foreign currency risk exposure that may result from one or all of the
following: (a) cash inflow and outflow gaps (different amounts of foreign currencies
received and/or paid out over a certain period of time), (b) interest rate exposure, and
(c) foreign currency hedging and interest rate hedging cash flows.

2.  Identify Risk Exposure Implications.  Once the source(s) of foreign currency risk
exposure have been identified, the next step is to identify and quantify the possible impact
that changes in the underlying foreign currency market could have on your balance sheet.  In
simplest terms, identify "how much" you may be affected by your projected foreign currency
risk exposure.

3.  Market Outlook.  Now that the source of foreign currency risk exposure and the possible
implications have been identified, the individual or entity must next analyze the foreign
currency market and make a determination of the projected price direction over the near
and/or long-term future.  Technical and/or fundamental analyses of the foreign currency
markets are typically utilized to develop a market outlook for the future.

B. Determine Appropriate Risk Levels:  Appropriate risk levels can vary greatly from one
investor to another.  Some investors are more aggressive than others and some prefer to take
a more conservative stance.

1. Risk Tolerance Levels.  Foreign currency risk tolerance levels depend on the investor's
attitudes toward risk.  The foreign currency risk tolerance level is often a combination of both
the investor's attitude toward risk (aggressive or conservative) as well as the quantitative level
(the actual amount) that is deemed acceptable by the investor.
2. How Much Risk Exposure to Hedge.  Again, determining a hedging ratio is often
determined by the investor's attitude towards risk.  Each investor must decide how much
forex risk exposure should be hedged and how much forex risk should be left exposed as an
opportunity to profit.  Foreign currency hedging is not an exact science and each investor
must take all risk considerations of his business or trading activity into account when
quantifying how much foreign currency risk exposure to hedge.

C. Determine Hedging Strategy:  There are a number of foreign currency hedging vehicles
available to investors as explained in items IV. A - E above.  Keep in mind that the foreign
currency hedging strategy should not only be protection against foreign currency risk
exposure, but should also be a cost effective solution help you manage your foreign currency
rate risk.

D. Risk Management Group Organization:  Foreign currency risk management can be

managed by an in-house foreign currency risk management group (if cost-effective), an in-
house foreign currency risk manager or an external foreign currency risk management
advisor.  The management of foreign currency risk exposure will vary from entity to entity
based on the size of an entity's actual foreign currency risk exposure and the amount
budgeted for either a risk manager or a risk management group.

E. Risk Management Group Oversight & Reporting.  Proper oversight of the foreign
currency risk manager or the foreign currency risk management group is essential to
successful hedging.  Managing the risk manager is actually an important part of an overall
foreign currency risk management strategy.

Prior to implementing a foreign currency hedging strategy, the foreign currency risk manager
should provide management with foreign currency hedging guidelines clearly defining the
overall foreign currency hedging strategy that will be implemented including, but not limited
to: the foreign currency hedging vehicle(s) to be utilized, the amount of foreign currency rate
risk exposure to be hedged, all risk tolerance and/or stop loss levels, who exactly decides
and/or is authorized to change foreign currency hedging strategy elements, and a strict policy
regarding the oversight and reporting of the foreign currency risk manager(s).

Each entity's reporting requirements will differ, but the types of reports that should be
produced periodically will be fairly similar.  These periodic reports should cover the
following: whether or not the foreign currency hedge placed is working, whether or not the
foreign currency hedging strategy should be modified, whether or not the projected market
outlook is proving accurate, whether or not the projected market outlook should be changed,
any changes expected in overall foreign currency risk exposure, and mark-to-market
reporting of all foreign currency hedging vehicles including interest rate exposure.

Finally, reviews/meetings between the risk management group and company management
should be set periodically (at least monthly) with the possibility of emergency meetings
should there be any dramatic changes to any elements of the foreign currency hedging
strategy.

FOREX RISK MANAGEMENT STRATEGIES

The Forex market behaves differently from other markets! The speed, volatility, and
enormous size of the Forex market are unlike anything else in the financial world. Beware:
the Forex market is uncontrollable - no single event, individual, or factor rules it. Enjoy
trading in the perfect market! Just like any other speculative business, increased risk entails
chances for a higher profit/loss.

Currency markets are highly speculative and volatile in nature. Any currency can become
very expensive or very cheap in relation to any or all other currencies in a matter of days,
hours, or sometimes, in minutes. This unpredictable nature of the currencies is what attracts
an investor to trade and invest in the currency market.

But ask yourself, "How much am I ready to lose?" When you terminated, closed or exited
your position, had you had understood the risks and taken steps to avoid them? Let's look at
some foreign exchange risk management issues that may come up in your day-to-day foreign
exchange transactions.

 Unexpected corrections in currency exchange rates

 Wild variations in foreign exchange rates
  Volatile markets offering profit opportunities
 Lost payments
 Delayed confirmation of payments and receivables
 Divergence between bank drafts received and the contract price

There are areas that every trader should cover both BEFORE and DURING a trade.

RISK DIVERSIFICATION

The majority of Indian corporates have at least 80% of their foreign exchange transactions in
US Dollars. This is wholly unacceptable from the point of view of prudent Risk Management.
"Don't put all your eggs in one basket" is the essence of Risk Diversification, one of the
cornerstones of prudent Risk Management.

Disadvantages of $-Rupee Advantages of Major currencies

1. The very nature or structure of the $-Rupee 1.By diversifying into a more liquid
market can be harmful because it is small, thin market, such as Euro-Dollar, the risk
and illiquid. Thus, dealer spreads are quite arising from the Structure of the Indian
wide and in times of volatility, the price can Rupee Market can be hedged
move in large gaps

2. Impacted in full by the Trend of the market. 2. Trends in one currency can be hedged
For instance, if the Rupee is depreciating, its by offsetting trends in another currency.
impact will be felt in full by an Importer Refer to graphs and calculations below.

3.Dollar-Rupee, in particular, brings the 3. These constraints do not apply in the

following risks: case of the Major currencies:
1) Lack of Flexibility...Payables once covered 1) Flexibility...Hedge contracts in Euro-
cannot be cancelled and rebooked Dollar or Dollar-Yen etc. can be entered
2) Unpredictability...Dollar-Rupee is not a into and squared off as many times as
freely traded currency and hence extremely required
difficult to predict. The normal tools of 2) Predictability...the Majors are much
currency forecasting, such as Technical more predictable and liquid than Dollar-
 Analysis are best suited to freely traded Rupee and hence Entry-Exit-Stop Loss
markets can be planned with ease, accuracy and
effectiveness

3) Lack of Information...Price information on 3) Free Information...The Internet

Dollar-Rupee is not freely available to all provides LIVE and FREE prices on these
market participants. Only subscribers to currencies.
expensive "quote services" can get accurate
information

4.$-Rupee rose 2.35% from mid-June to 11th 4.Euro-Rupee fell 4.63% over the same
Aug. period

5.· An Importer with 100% exposure to USD, 5.An Importer with 25% exposure to the
saw its liabilities rise from a base of 100 to Euro saw its liability rise from a base of
102.35 100 to only 100.60

Even if a Corporate does not have a direct exposure to any currency other than the USD, it
can use Forward Contracts or Options to create the desired exposure profile. Thankfully, this
is permitted by the RBI. This is not Speculation. It is prudent, informed and proactive Risk
Management. As seen, the bad news is that Dollar-Rupee volatility has increased. The good
news is that forecasts can put you ahead of the market and ahead of the competition.

CONCLUSION

In a universe with a single currency, there would be no foreign exchange market, no

foreign exchange rates, and no foreign exchange. But in our world of mainly national
currencies, the foreign exchange market plays the indispensable role of providing the
essential machinery for making payments across borders, transferring funds and purchasing
power from one currency to another, and determining that singularly important price, the
exchange rate. Over the past twenty-five years, the way the market has performed those tasks
has changed enormously.Foreign exchange market plays a vital role in integrating the global
economy. It is a 24-hour in over the counter market –made up of many different types of
players each with it set of rules, practice & disciplines. Nevertheless the market operates on
professional bases & this professionalism is held together by the integrity of the players.

The Indian foreign exchange market is no expectation to this international market

requirement. With the liberalization, privatization & globalization initatited in India. Indian
foreign exchange markets have been reasonably liberated to play there efficiently. However
much more need to be done to make over market vibrant, deep in liquid. Derivative
instrument are very useful in managing risk. Some of the popular derivate instruments are
forward contract, option contract, swap, future contract & forward rate agreement. However,
they have to be handle very carefully otherwise they may throw open more risk then in
originally envisaged.