Risk Management Tools

&
India’s External Position
Risk Management Tools
Hedging?
• Life in Hedging
• Difficult to accept undesirable outcomes
• Obsessed with hedging future
• Certainty
• Plan B
Hedging Tools
Volatility

Nature Of Market Economic Factors Local Factors ( $/INR)

Demand & Supply; Capital

Size, Market Place, Regulatory Control Data, Events, Fundamentals
Flows

Technical Analysis Models Interest Rates; Carry Trades RBI, Political Climate
Risk Calendars
USD Overdue Nov-22 Dec-22 Jan-23 Feb-23 Mar-23 Apr-23 Next 6 months Grand Total
EEFC bal 0.05 0.05
EXPORT Exposure 3.47 5.24 4.27 3.93 3.62 3.38 3.44 27.35
IMPORT BL Exposure 0.00 -0.65 -0.65 -0.65 -0.65 -0.65 -0.65 0.00 -3.91
Cross Currency
0.00 0.00 0.51 -0.52 -0.52 0.00 0.99 1.03 1.49
Derivatives
FC-USDINR-Buy
FC-USDINR-Sell -2.03 -4.50 -5.00 -4.00 -2.90 -1.58 -1.20 -21.21
Grand Total 3.52 2.56 -0.37 -2.24 -1.55 -0.18 2.19 -0.18 3.77
Risk Management Tools
Risk Management Tools
Forwards & Futures
Forward Contract: A foreign exchange contract that matures on a date
later than the spot value date is known as a forward contract
The main use of forward contracts is to hedge actual and forecast currency
exposures that will crystallize at a future date

Future Contract: 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 – Premium & Discounts
Currency with lower interest rate will be at premium
Currency with higher interest rate will be at a discount
Forward premiums are a function of interest rate differential between the
two currencies of the pair

Export Import Export Import

Period
Premium Premium Forward Forward
Spot 81.80 81.81

Fwd 1M 0.12 0.13 81.92 81.94

Fwd 3M 0.37 0.38 82.17 82.19

Fwd 6M 0.81 0.82 82.61 82.63

Fwd 9M 1.31 1.32 83.11 83.13

Fwd 1Y 1.87 1.88 83.67 83.69

Hedging Example
● An company in the auto components industry has a monthly forex exposure of
$100,000 on account of imports

Without Hedging
Transaction Date USDINR Spot Value in INR
28-Apr 81.80 81,80,000
31-Oct 83.00 83,00,000
Exchange Profit/(-Loss) -1.20 -1,20,000

With Hedging
Transaction Date USDINR Spot Value in INR
28-Apr 81.80 81,80,000
Forward Rate: 31st Oct 82.60 82,60,000
31-Oct 83.00 83,00,000
Exchange Profit/(-Loss) 0.40 40,000
Forwards vs Futures
Sr no. Currency forwards Currency futures
Currency futures are traded in exchange i.e.
1 Forwards are traded in Bank.
NSE.
Transacting via Bank takes time - Like calling
Dealing in currency futures is quick. It will
theBank, negotiating with them and then
2 nottake more than 10 seconds.
finalizing the rate.

The difference between Bid and Ask is usually The difference between Bid and Ask is not
3 1 to 2 paisa. more than 0.5 paisa.

Booking a forward involves taking spot rate

Currency futures contract has one single rate
initially and then fixing at the required
of that particular contract. For e.g. October
maturity. The forward premium between spot
2022 contract. So the extra spread of 2-3 paise
4 and the saidmaturity again has the spread of
can besaved on each side of the transaction
2-3 paisa.

Underlying documents are required before or No documents are required for doing any
5 after doing a transaction. number of transactions.
6 Amount is customized It is traded in lots of 1,000 units (USD, EUR)
No fixed maturity. Forwards can be parked to It has fixed maturity. 2 days prior to Last
7 any date. working day of every month, even weekly
expiries available now
Note Fonts colored in blue has an advantage over fonts colored in red.
Forwards vs Futures
Sr no. Currency forwards Currency futures
No margin is required while transacting with Upfront margin is required before entering the
8 bank currency futures contract

No mark-to-market settlement is done on daily Here after entering into the transaction, mark-
9
basis for outstanding contracts to-market is done regularly
No funding is required if the position goes Funding has to be done if the transaction is
10 against the desired direction against the desired direction

11 Liquidity is available for all 12 months Liquidity is available only for the first 3 months

The cost of one single transaction (booking The cost of one single transaction (booking and
12 andcancellation) is higher in most cases cancellation) is lower comparatively
(considering margins and spreads)

Can also protect desired rate by buying the

option - paying some nominal premium for any
particular future date. This helps in volatile
markets. Unlike futures, buying option doesn’t
13 have unlimited downside if the marketgoes
against position. The maximum loss isthe
Options through banks are comparatively premium paid while buying the option.
expensive and less transparent However if the market moves in favour one
gets full benefit
Options
Options
• Provides the buyer of options the right but not the obligation to buy/sell
foreign currency at an agreed price at a future maturity date for a
premium
a. Buying Options is akin to buying insurance to manage risk, wherein premium is paid to
protect exposure.
• Provides the seller of options the obligation but not the right to buy/sell
foreign currency at an agreed price at a future maturity date in exchange
for a premium
• Selling options can be a consistent way to generate excess income – but extremely
risky in case we don’t have the exposure.
Advantages of Options
• For option buyers, the primary advantage is risk coverage with fixed cost
• In case of heightened volatility, uncertain times options are the best to
ensure desired conversion rates
• Exercised only when contingent risk materializes
• Upside fully open – when currency moves in our favour we can get the full
benefit (when long on options)
• Option structures are available for managing exposure at reduced cost
with some open risk
• Cost can be reduced by slight restructuring
• Options can be also traded and terminated in case view changes
Plain Vanilla CALL Option
• Mainly used for protecting import exposure
• It is an alternate to forward/future contract

• Example, Buy Call @ 80.5, Premium: 0.90 p

• Above price is calculated at spot ref. of 79.90
• The tenor for the above option is 3 months
• The above cost protects if market goes above 80.5, but with additional payment of 0.90
Rs/USD (PS: Vega - volatility greek – is very high)
• Effectively our imports will be paid off at 81.40 (in case prices are above 80.50)
• Effectively our imports will be paid off at Spot + 0.90 (in case prices are below 80.50)
• The forward booking for 3 months at spot of 79.90 gives us 80.50
• If the market remains below 80.50, we pay our import at whatever the ruling spot rate.
• If the spot rate is below 79.60 on the date of payment of import, the option premium
cost would be fully recovered and will give us better rate than the forward booking
Plain Vanilla CALL Option
Buy Call: Strike 80.5

CMP: 79.90
Tenor: 3 Months
Net Premium Paid: 0.90

Forward Rate: 80.50

Plain Vanilla PUT Option
• Mainly used for protecting export exposures.
• It can also be used for managing Import hedges.

• For example, Buy Put at 80.00; Premium INR 0.56

• If the market trades below 80.00, we have right to sell at 80.00
• If the spot rate is above 80.00 we can sell at ruling market rate
• Forward cover for the same tenor at spot of 79.90 comes to 80.50
• While protected below 80.00, we get entire upside if rupee depreciates
Plain Vanilla PUT Option
Sell Put: Strike 80

CMP: 79.90
Tenor: 3 Months
Net Premium Paid: 0.56

Forward Rate: 80.50

Range Forward Structure - Export
• Range forward is a combination of buying PUT and selling CALL
• We pay premium for buying a PUT option at strike 80.00, but the same is partially
made up by the premium we receive selling CALL option at strike 82.00
• Higher the PUT strike we desire, lower the CALL strike we have to sell to make up
for the premium cost
• While we get protection at BUY PUT strike for 3 months, if the market moves
above the SELL CALL strike, we have an obligation to sell Dollars at that rate at sell
call strike (i.e. 82.00)
• In this case effective hedge rate would be sell call strike - premium paid i.e. 81.75
(82 - 0.25)
• If market rates are below 80 at maturity, we have right to sell export at 79.75
(80.00 - 0.25)
• This is recommended when we expect market in uptrend but with limited scope &
would forego something for protection in case markets move otherwise
Range Forward Structure - Export
Buy Put: Strike 80.00
Sell Call: Strike 82.00

CMP: 79.90
Tenor: 3 Months
Forward Rate: 80.50

Net Premium Paid: 0.25

SEAGULL STRUCTURES – Import
• A cost reduction structure
• Premium payable on CALL OPTION BUYING is reduced by SELLING A CALL OPTION
apart from SELLING A PUT OPTION
• What we are foregoing is two things-
• Protection beyond 82.00; if spot is above 82.00 on maturity, we have no insurance beyond 82.00
• If the market drops below 79.00, we are locked at 79.00; so even if market goes to 75 we have
obligation to buy Dollars at 79.00
• If the market stays between 79.00 and 80.50, we can book imports at market prevailing rate bring
the hedge at Spot + 0.30
• If the market rate is between 80.50 and 82.00, our hedge is fixed at 80.50 bringing the hedge rate at
80.80 (80.50 + 0.30)
• If we improve our BUY CALL rate, either we have to SELL CALL at lower strike or
SELL PUT at higher strike
• It is best recommended when market is perceived to be in an uptrend for the
tenor of the import liability, but in our estimate not likely to move beyond some
level
• To be effective, we have to choose SELL CALL at a strike that has lower probability
of being seen
SEAGULL STRUCTURES – Import
Buy Call: Strike 80.50
Sell Put : Strike 79.00
Sell Call: Strike 82.00

CMP: 79.90
Tenor: 3 months
Net Premium Paid: 0.30

Forward Rate: 80.50

Call Spread – Import

• Call Spread is known as a cost reduction structure, as it subsidizes the

cost of buying options through the sell leg of option
• Premium payable on CALL OPTION BUYING is reduced by SELLING A CALL
OPTION
• It can be observed we are able to get protection at 75.5 with a possibility
of booking even lower while the forward rate is fixed at 75.44
• With this structure we have our upside improvement on the hedge rate
limited if spot moves higher i.e. till 77
• But no limits on gains in case exchange rate moves downwards
Call Spread Structure - Import
Buy Call: Strike 80.50
Sell Call: Strike 82.00

CMP: 79.90
Forward Rate: 80.50

Net Premium Paid: 0.54

 Summary
Particular Forward Contracts Call (Buy) Put (Sell) Range Forward Call Spread Seagull

Right to buy USD at Obligated to buy USD if

Buy outright USD Combination of Buy Call & Combination of Buy Call Combination of Buy Call, Sell
Structure strike rate on future prices below strike
for the future date Sell Put & Sell Call Call and Sell Put
date (premium gain)

Expectations of a range Expectations of a range

Ranged moved for USDINR
Limited/ranged move movement for USDINR with movement for USDINR
with less expectations for
Firm view for USD Lesser certainty of for USDINR or slight chances of USD with slight chances of
Views any sharp appreciation for
appreciation USD appreciation expectation of USD appreciation - also provides USD appreciation - also
USD - also participation in
depreciation participation in USD provides participation in
the USD depreciation
depreciation USD depreciation

Partial Hedge -
Partial Hedge - Protection
Partial Hedge - Protection Protection above buy
Full Hedge - no Partial Hedge - No hedge - no above buy call strike but
above call call strike but only till
participation in protection above protection against only till sell call
strike,participation in USD sell call
Hedge price movement strike rate and full exposure, premium strike,participation in USD
depreciation till put strike, strike,participation in
after booking - participation in USD gains to offet some depreciation till sell put
no protection below put USD depreciation, no
cashflows fixed depreciation moves on the upside strike, no protection beyond
strike protection beyond sell
sell call and sell put strike
call strike

High - equivalent Lower than buy call - Lower than buy call -
Earnings in the form of Lowest of the all structures
Cost to ongoing Higher than forwards subsidised due to selling subsidised due to selling
premium mentioned
premium option option
Ascertains
Higher risk on sharp
cashflow - no Very high risk - Opportunity loss on USD Higher risk on sharp
Max loss of premium appreciation of USD
Risk participation in unlimited loss potential, depreciation beyond put appreciation of USD beyond
paid beyond sell call strike
favourable price limited profit strike - no to very low risk sell call strike levels
levels
movement
Exotic Options

• Exotic options have non-standard features that enable them to be tailored

to individual risk management needs
• Exotic option structures incorporating written options can provide
businesses with effective low-cost hedges
• Compared to vanilla options, difference is with regard to the payment
structures, expiration dates and strike prices
• Payoff structure, unlike the traditional Option’s payoff structure, is based
on not only the value of the underlying currency at maturity but also on its
value several times during the course of the contract's life
• Initially banned by RBI for lack of transparency, later to be reintroduced
again but with very low acceptance/liquidity
Barrier (Knock In/Out) – Exotic Options
• Triggered when the underlying asset or instrument reaches the
predetermined price, rest similar to vanilla options
• If the currency remains below knock in level, the Option will become
worthless and it will not exist, vice versa for knock out
• If the currency hits knock in level, the option is triggered and can be
exercised according to the strike on maturity
• Can exercise an Exotic Option at a lower premium (cost of investing in
Option) as compared with traditional Option
• Other types of Barrier Options:
– Up-and-Out - Price of the currency goes up and Knocks-out the Option
– Down-and-Out - The Price goes down and Knocks-out the Option
– Up-and-In - Price goes to the specific level and Option gets initiated
– Down-and-In - Price falls down to the required level and Option gets Knocked-in
Forward Extra
• Structure consists of Buying a Put Option along with selling a Call Option (Call option
gets active with a trigger)
• In case of forward extra – Put & Call option are generally of same strike but only Put
option is exercisable on maturity if the barrier prices levels are not traded in the tenor
• If the barrier levels are traded during the tenor, the sell call option is active bringing
the net effective hedge at same strike as of put
• Structure is same as booking a forward option but with conditional participation in the
currencies movement in the desirable direction
• Forward as hedging instruments fixes the rate for conversion of receivables of certain
date in the future which ought to be obliged
• Characteristics of USDINR:
o INR depreciates in bouts and then consolidate for long periods

o Past 20 years, average depreciations(avg. 20% in quantum) cycles have been of 7 months while consolidation
runs for more than 20 months
Forward Extra
• Forward extra provides the hedge at same levels as that of a forward - but doesn’t
fix/obligate company to convert the receivables of future date on that rate
• The structure provides opportunity to participate in INR depreciation - convert on
exchange rate(if higher than forward rate) as on maturity date - so long the trigger level is
not hit
• Negative MTM - certain in such scenario with forwards – will turn into better cashflow
gains with forward extra (subject to trigger)
• If trigger levels are hit even once during tenor – conversion is fixed at forward rate
• Forward extras – come at certain cost – comparatively lower than plain vanilla options
Structure booking – 14th March 2023
• Spot Rate: Rs 82.43 Forward Rate: 83.42
• Buy a Put @ 83.00 [Minimum realization rate]
• Sell a Call @ 83.00 [Realization rate if Triggered], trigger level at 88
• Tenor: 6 Month (15th Sept 2023) Option Premium: Net 33 paise/USD to pay
USD INR at Expiry 80 81 82 83 84 85 86 87 88 89 90
Forward Rate 83.42
Net Realization
82.67 82.67 82.67 82.67 83.67 84.67 85.67 86.67 82.67 82.67 82.67
Rate less premium
Forward Extra
Pros Cons
• Comparatively low cost • Risk of higher loss in event of large
• Create a customized hedge move but same as forward
• Limiting losses for the writer • Unwind costs higher/dependency on
• Protects same rates as forward with Banks
participation capability • Lack of transparency & Liquidity
Treasury Approaches
India’s External Position
India’s External Position
 BOP - Components
Balance of Payment
Current Account Capital Account

➢ All Flows of Goods, Services, Primary income &

Secondary Income
➢ Foreign Investment:
• FDI
➢ Merchandise: Export & Import of goods
• Portfolio Investment
➢ Invisibles:
➢ Loans
• Transportation
• External assistance- Bilateral/Multilateral
• Travel
loans under govt. arrangement
• Insurance
• Commercial Borrowings
• MISC:
• Short Term Loans
❖ Software Services
❖ Business Services
➢ Banking Capital- Assets/Liabilities & Deposits
❖ Financial Services
➢ Errors and Omissions: Since BOP data is received
➢ Current Transfers:
from various sources, it is practically impossible to
• Grants/Gifts/Remittances who do not have any
tally
quid pro quo
• Salaries
 AMOUNT IN USD BILLION

-40
-20
0
20
40
60
80
100

26
FY05

16
FY06

36
FY07

91
FY08
FY09

-21
13
FY10

16
FY11
FY12

-10
1
FY13

16
FY14
BOP (A+B)

62
FY15

19
FY16

22
FY17

43
FY18

-3
FY19
59

FY20
88

FY21
47

FY22
FY23 (6M)

-25
Historic BOP Numbers

0%
5%
10%
15%
20%
25%
30%

-15%
-10%
-5%
FY05
1%

FY06
2%

FY07
-3%

FY08
-7%

FY09
26%

-11% FY10
FY11
-1%

FY12
14%

FY13
7%

FY14
10%

FY15
4%
INR Movement

FY16
7%

FY17
-2%

FY18
1%

FY19
6%

FY20
9%

FY21
-4%

FY22
3%

FY23 (6M)
7%
 Historic BOP Numbers
Net Current Account (A) Net Capital Account (B)
40 120

24 107

20 100
89 89 91
86
83
0

AMOUNT IN USD BILLION

80
AMOUNT IN USD BILLION

68
-2 -10-10 64 64
-20 -16 -14
60 54
-22 52
-27 -25 49 51
-28
-32 45
-40 41
-38 -39 40 36
-48 -49 28
25
-60 -57
20

7
-80 -78
-78
0
-88
-100
Characteristics of Current Account

Net Current
Period
Merchandise Trade Invisibles
Account
% of Merchandise met Net Current Account is Merchandise
Surplus/(Deficit) [A] Surplus/(Deficit) [B] by Invisibles Trade+ Invisibles Trade
[A+B]

FY10 -118.2 80.0 -38.2 68% Invisibles contains the following head:
-> Services
FY11 -127.3 79.3 -48.1 62% -> Transfers
FY12 -189.8 111.6 -78.2 59% -> Income

FY13 -195.7 107.5 -88.2 55%

FY14 -147.6 115.3 -32.3 78%
Median value of Invisibles Surplus
FY15 -144.9 118.1 -26.9 81%
meeting Merchandise deficit: 74%
FY16 -130.1 107.9 -22.2 83%
FY17 -112.4 98.0 -14.4 87%
FY18 -160.0 111.3 -48.7 70%
FY19 -180.3 123.0 -57.3 68%
FY20 -157.5 132.8 -24.7 84%
FY21 -102.2 126.1 23.9 123%

FY22 -189.5 150.7 -38.8 80%

FY23 -284.0 206.0 (E) -78.0 73%
Merchandise Trade Composition
Energy Dependence

Coal,Coke,Petroleum,Tar,Lubricants,Jet Fuel,LNG Energy as a % of total imports

[Termed as Energy] 33%

32%
FY-22 195
31%
FY-21 102
30%
FY-20 154
29%
FY-19 168
28%
FY-18 132
27%
FY-17 103
26%
0 50 100 150 200 250
25%
AMOUNT IN USD BILLION
FY-17 FY-18 FY-19 FY-20 FY-21 FY-22

Crude Oil Imports Crude Oil as a % of Total Imports

23%
FY-23 118
22%
FY-22 100
21%
FY-21 62 20%
FY-20 101 19%

FY-19 112 18%

FY-18 88 17%
16%
FY-17 70
15%
0 20 40 60 80 100 120 140
14%
AMOUNT IN USD BILLION FY-17 FY-18 FY-19 FY-20 FY-21 FY-22 FY-23
Services Trade Composition

Services Trade Composition

300
AMOUNT IN USD BILLION

208 206

164 166
158
125 146
126 118 133
106
96
82
74 81 81 82 89
52 77 68
43 44 65
54 44
28 29
15

Services Exports Services Imports Net Services Trade

Software Services

Software Services Exports has

Net Software Services Export contributed on an average 43% of
total net credit received from services
120
110 FY22-48%
FY21-48.5%
100
90
85 Assuming the average figures Software
Services figure should be
80 78 approximately USD 130 billion in FY23
AMOUNT IN USD BILLION

70 71 71 72
67
64 63
61 Components of Software % of Software
60 Exports Exports
51
48 IT Services 62.70%
44 Business Process Outsourcing 27.50%
40 37 Software Product Development 3.13%
Engineering Services 6.67%
29
22
20 17
12
9
6 7

0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23