Hedging Techniques Of Bilateral Exchange Rate


02 Nov 2017

This essay has been written and submitted by students and is not an example of our work. Please click this link to view samples of our professional work witten by our professional essay writers. Any opinions, findings, conclusions or recommendations expressed in this material are those of the authors and do not necessarily reflect the views of EssayCompany.


This paper presents the analysis of hedging techniques of Bilateral Exchange Rate between India and Saudi Arabia. The analysis has been done for the oil and petroleum product trade flow between India and Saudi Arabia. India imports crude oil from Saudi Arabia and exports petroleum products to it. The payment between both the countries for the import and export takes into account the foreign exchange rate. Hence, there is always the risk that the foreign exchange rate will change during the realization of the contract because of which one party will lose and other will gain some amount.

Due to these changes in foreign exchange rate, the volume of exports and imports may change. One of the objectives of this paper is to find the impact of exchange rate instability on India’s trade (export and import) with Saudi Arabia.

When companies conduct business across borders, they must deal in foreign currencies. Companies must exchange foreign currencies for home currencies when dealing with receivables, and vice versa for payables. This is done at the current exchange rate between the two countries. Foreign exchange risk is the risk that the exchange rate will change unfavorably before the currency is exchanged.

A foreign exchange hedge (FOREX hedge) is a method used by many companies to eliminate or hedge foreign exchange risk resulting from transactions in foreign currencies.

One of the more common corporate uses of derivatives is for hedging foreign-currency risk, or foreign-exchange risk, which is the risk that a change in currency exchange rates will adversely impact business results. 

The findings of this research are that the exchange rate trend of India with respect to the US Dollars is a depreciating trend. The exports and imports of India depend largely on the exchange rate of India vs. US dollars. As the Exchange rate of India decreases, then the export price becomes cheap and hence the exports of India increase. Similarly, the imports price becomes expensive and there will be a decrease in the imports of India.



There are various ways to look at oil industry. As per the the personal perspective, oil and gas provide the world's population with 60% of their daily-essential energy needs. The other 40% comes from nuclear, coal and renewable like wind, tidal and solar power, bio-mass products like biogas.

They are used as fuels as they keep us warm in cold weather and cool in hot weather, they are used to cook food and heat the water, they generate electricity and power up the appliances; and they are used in cars, buses, trains, ships or planes for transportation purposes. We all feel the economical pinch when prices of the gasoline, or any other fuel or electricity increase sharply.

They are also used as petrochemical feedstock, oil and gas are raw materials used for manufacturing the fertilizers, synthetic rubber and the plastics that are used to manufacture many other things such as toys, personal items and household items and also heavy-duty goods.

From the business perspective, the oil and gas industry represent global commerce on a massive scale. The Energy markets across the world are continually expanding and companies are spending around billions of dollars to maintain and increase their oil and gas productions. Over 200 countries have liberalized and invited companies to negotiate the right to explore their lands and territorial waters, hoping that they can find and produce the oil and gas, also creation of local jobs and provide billions of dollars in national revenues.

From geopolitical perspective, very large quantities of oil and gas flow from "exporting" regions such as the Middle East, Latin America and Africa to "importing" regions such as North America, the Far East and Europe. This generally creates political, economic, trade and national security concerns on both the sides. Oil and gas exporters always want to maximize their revenues and profits, improve their trade balances and also maintain the control over their natural resources. Similarly, importing nations also want to minimize their trade deficits and ensure a, reliable, steady oil supply.

From internal policy perspectives, the producing countries such as middle-east countries continuously boggle their minds with questions such as how to develop their resources in the best way, attain long-term benefits for their people sustainably. Also similarly, consuming countries such as India, always consider how to decrease their dependence on imported oil, by imposing higher energy taxes to increase conservation, or tapping into domestic resources like coal and developing alternative sources of energy such as renewable and nuclear.

These issues have long-term impacts, within individual countries and also on the world at large, even affecting fundamental issues such as war and peace.

The Oil Industry is more than 5000 years old. The first oil well drilled in china at 347 A.D. was up to 80 ft deep and was dug using bit attached to the bamboo pile. In 1735, oil was extracted from the oil sands in Pechelbronn field in Alsace, France. According to the history, first structured oil well was built in Gulf of Mexico. The place where it was made was on a place which was around 100 meters deep. This was beginning of making of structured well on the lands and on the waters. 

Since the beginning oil had a limited use, but in 19th century the process of distillation of kerosene through rock oil and coal invented. In 1848, first modernized oil well was drilled in Asia. The oil has been a very important commodity always to the human beings. Until 1950 coal played dominance among all primary energy constituent and then crude oil took over in a small amount of time and has maintained reputation till now. Nowadays, Crude oil is the source of approximately 40 percent of the total energy in world.  The importance of oil reached a level where there is no country, which does not want oil and need it to meet its requirements, and if it does not has much reserves of the oil to meet its domestic demand, these nations then import oil at any cost.

Organization of the Petroleum Exporting Countries has been contributing to the crude oil reserves for more than 80% of world. OPEC was formed in 1960 consisting of five founder members which are Iran, Iraq, Kuwait, Venezuela and Saudi Arabia. It took around a decade to make its influence known in the world market. By 1971 six other nations also joined this group. In terms of crude oil the world can be divided into OPEC countries and Non-OPEC countries. OPEC countries have major crude oil reserves. Country-wise Saudi Arabia has the largest crude oil reserves of 264,516 million barrels and then Venezuela overtook it in 2010 as it had crude oil reserves of 296,501 million barrels as opposed to 211,173 million barrels in 2009, then comes Iran with 151,170 million barrels and then Iraq with 143,100 million barrels.

Total world crude oil production in 2010 had been 69.7 million bpd. The major producer of crude oil is Russia and it acquired no. 1 position. It has 9.8 million bpd and then Saudi Arabia with 8.16 bpd and then USA which has around 5.5 million bpd. OPEC has the highest Crude oil reserves and it produces 42 percent of the total world oil production, and OECD has 4% of crude oil reserves but produces 19% of total crude oil production.

The crude oil is fulfilling world’s 45% energy demand. United States is consuming around 18.9 million bpd, which is approximately 24% of total world crude oil consumption and that is around 80.3 million bpd. It stands at number one position and then is China at 8.43 million bpd, then Japan at 4.43 million bpd and after that is India at 3.182 million bpd.

The crude oil prices and supply have seen many upward and downward trends in the past years. The crude oil supply changes are due to many factors, such as:

Declining production due to depleting reservoirs.

Lack of investments.

Lack of proper secondary and tertiary production technologies.

Availability of alternate sources of energy such as renewable.

Internal unrest in the countries, for example, Arab springs, where the production in Egypt, Libya and Bahrain declined due to public unrest.

The crude oil prices change due to many factors such as:

Changes in supply and demand.

Speculation in the physical oil market.

Geopolitical issues such as the Iran sanctions imposed by USA.

Interventions of OPEC.

War and terrorism.

Energy security scenarios in various countries.

The global productivity of crude oil all over the world is 83576 thousand barrels per day. Out of this, OPEC’s production is 35830 thousand barrels per day. OECD countries’ production is 18543 thousand bpd. Non-OECD production is 65032 thousand bpd. European Union production is 1692 thousand bpd. Former Soviet Union production is 13487 thousand bpd.

The global consumption is 88034 thousand bpd. Out of this, OECD consumption is 45924 thousand bpd. Non-OECD consumption is 42111 thousand bpd. European Union consumption is 13478 thousand bpd. Former Soviet Union consumption is 4110 thousand bpd.

The consumption pattern of crude oil across the world is:


Consumption in 2011 (Tbpd)







Total North America














Trinidad & Tobago




Other S. & Cent. America


Total S. & Cent. America












Czech Republic














Republic of Ireland


















Russian Federation
















United Kingdom




Other Europe & Eurasia


Total Europe & Eurasia










Saudi Arabia


United Arab Emirates


Other Middle East


Total Middle East






South Africa


Other Africa


Total Africa








China Hong Kong SAR










New Zealand








South Korea








Other Asia Pacific


Total Asia Pacific


Total World


The consumption pattern of petroleum products across the world is:

Countries and Product

Consumption (2011)

North America

Light distillates


Middle distillates


Fuel oil




Total North America


of which: US

Light distillates


Middle distillates


Fuel oil




Total US


S. & Cent. America

Light distillates


Middle distillates


Fuel oil




Total S. & Cent.





Middle distillates






Total Europe


Former Soviet Union

Light distillates


Middle distillates


Fuel oil




Total Former Soviet Union


Middle East

Light distillates


Middle distillates


Fuel oil




Total Middle East



Light distillates


Middle distillates


Fuel oil




Total Africa


Asia Pacifi c

Light distillates


Middle distillates


Fuel oil




Total Asia Pacific


of which: China

Light distillates


Middle distillates


Fuel oil




Total China



Light distillates


Middle distillates


Fuel oil




Total Japan



Light distillates


Middle distillates


Fuel oil




Total World



Light distillates


Middle distillates


Fuel oil




Total OECD



Light distillates


Middle distillates


Fuel oil




Total Non-OECD


European Union

Light distillates


Middle distillates


Fuel oil




Total European Union



India has a growing economy, and it is an increasingly the important consumer of energy. Coal accounts for nearly 40% of India’s energy consumption, which is followed with nearly 27% for renewable energy. Crude Oil accounts for around 24% of the total energy consumption, and then natural gas which is 6%, after this is hydroelectric power which is around 2%, and, nuclear energy is around 1%. Specifically, transport sector’s energy demand has been expected to increase rapidly.  India has 5.7 billion barrels of proven oil reserves as of 2012, which is second-largest in the Asia-Pacific region and the first is China.

The crude oil production in India is around 858 thousand barrels per day. Whereas, the consumption and demand in India is 3473 thousand barrels per day.

The imports of India for crude oil by source are:

The various industries in India that depend on crude oil imports are:


Petrochemical units.

Agricultural industry.

Transportation sector.


Foreign exchange reserves.




Generally crude oil is sold by various contracts and agreements and also in spot transactions which are usually physical trading. Also, Oil is bought and sold on futures markets and exchanges, but that is not the physical supply of volumes of oil, but it is more a mechanism to manage and distribute risk. All these mechanisms help in providing the pricing information to the oil markets.

Now, the crude oil pricing mechanism has become transparent from 1990s and onwards because of the use of marker crudes such as:

West Texas Intermediate (Western Texas Intermediate – USA)

Dubai, Tapis and Dated Brent (in Asia-Pacific)

Dubai and Oman (Middle East)

Brent (Europe, Africa and Asia)

The import prices of many of these marker crudes are provided by the exchanges on which these marker crudes are traded. For example, WTI is traded in New York Mercantile Exchange (NYMEX) and NYMEX provides the pricing information about the WTI marker crude.

The import pricing information about the crude oil is also provided many of the publications. Some of the renowned publications which provide the pricing information for crude oil are:



London Oil Report

There are also various mechanisms that are used to price various energy commodities including crude oil:

Fixed and Flat Pricing:

In this, the price of crude oil is agreed at the time of trade. For example, USD 15 and this cannot be altered.

Formula Pricing:

It gives the price that is an average of a date range of market prices. For example, monthly averages and weekly averages

Trigger Pricing:

Trigger pricing is a mechanism by which the traders can negotiate the price of portions of the quantity of the commodity over a period of time. The final price of trigger will be the weighted average price of the portions.

Date related Pricing

This gives the price of crude oil which is the average of market prices around a particular date. It is similar to the formula pricing except rather than having a start and end date, it uses a delivery date. For example, Bill of Lading date is when the commodity loads; the Discharge date is the day it discharges.

Percentage pricing:

Percentage pricing gives the price of crude oil by calculating a basket of market prices each with different percentages.

Exchange for Physical Pricing:

The physical commodity is paid for with its futures contract. The final pricing decision is independently controlled by each party through reversal of their futures position. The one party with the physical position and other with the crude oil future contract exchanges their positions with each other. The one with the physical position delivers crude oil to the other party and get the future contract in return.

Generally, the pricing of physical crude oil trade is based on a formula approach (as discussed above) wherein the marker crude is used as base and then a differential, based on the quality of the crude oil being purchased (premium/discount), and also based on the demand/supply scenario of the crude oil being purchased(premium/discount), is added. Therefore, in times of tight supply the premium will increase and gradually increase up the Marker crude oil price, while in times of increased supply, a decreased premium or a discount will decrease the Marker crude price.

When we take a look at the oil price mechanisms that existed in India, we find that these mechanisms have been changed continuously to reflect the changing crude oil scenario in this country. From 1950s, when India imported majority of its oil demand, mechanism of import parity pricing prevailed until 1970s by which India’s oil price was in sync with the international prices. With the discovery of the Bombay High reserve and hence the increasing refinery capacity of India there had been a sudden decrease in the imports of the crude oil. It was hence decided to provide India with the advantage of the domestic production by providing and approving the Administered Pricing Mechanism (APM) in India. This mechanism helped in insulating the domestic oil prices of India from international prices of crude.


Review of Literature




The variables recurred for this study are bilateral exchange rate of India and US (as the payment terms between India and UAE is US Dollars, export price and import price of India for the study period (December 1999 to September 2012), export value and import value of India for the study period (December 1999 to September 2012). The dependent variables are the export values and import values of India to and from the United Arab Emirates. The independent variables are export price of India to UAE, import price of India from UAE and the exchange rate between Indian rupee and the US dollars as the payment term between India and UAE is US dollars.

The independent variables are lagged variables to analyze the model dynamically, wherein the effect of previous months’ export price and exchange rate is analyzed on current months’ export value of Indian exports and also the effect of previous months’ import price and exchange rate is analyzed on current months’ import value of Indian imports.


Secondary data is going to be used for this study. The data sources follow:

IMF statistics.

RBI Indian data series.


UNCTAD statistics.

World Bank Data statistics.

Primary data is not relevant and not used in this study.


Moving Average

In statistics, a moving average, also known as the rolling average or rolling mean, is the type of finite response analyzer used to analyze a set of data by the creation of a series of averages of the different subsets of the entire data set points.

If there is a series of numbers and the fixed subset size, then the first element of this moving average is generally obtained by taking the simple average of the first subset of the data in the number series. Then the subset is shifted forward, that is, the simple average is taken from the second data in the subset of data series (excluding the first number of the series). This will create a new sub-set of data numbers, which is again averaged. This process is continued for the entire series of data. The plotted line which connects all the fixed simple averages is moving average. The moving average is a set of numbers, in which each of the average is the average of the corresponding subset of the larger set of the data points.

The moving average is usually used for time-series data to smoothen out the short term fluctuations and hence highlight the longer term trends. Threshold between the short term and the long term trend will depend on the application, and also the parameters that are taken for the moving average that are set accordingly. For example, moving average is often used in the technical analysis of the time-series financial data, like, returns on trading volumes, stock prices, etc. Moving average is also used in the economics for examining the GDP, employment trend or any of the other macroeconomic time series data. When moving average is used with the non-time series data, it filters out the higher frequency compositions without any particular connections to the time, although some kind of ordering should be implied. Simply, it can be viewed as smoothing of the data. To analyze the instability of exchange rate, import trends and export trends of India, it is decided to use Moving Averages.

Multiple Linear Regression Technique

It is a technique wherein the effect of two or more variables is analyzed on a dependent variable. The degree of the equation is one. Hence, it is linear regression technique. Also, the independent variables are more than one; hence, it is multiple regression technique.

The very simplest case is the single scalar predictor variable which is the independent variable and a single scalar dependent variable which is known as simple linear regression. The extension to this is the multiple independent or predictor variables and is known as multiple linear regressions. All the real world models of regression involve multiple predictors/independent variables and the basics of linear regression are often based on the terms of the multiple linear regression model.

Multiple Linear Regression technique is planned to use for this study. The model to be used is as follows:


X = Value of Export of India to UAE in time period t.

M = Value of Import of India from UAE in time period t.

ex = Bilateral Nominal Exchange rate between India and UAE.

ep = Export price of India

ip = Import price of India.

t= Time

E = Error term.

β0 and β1 = Coefficients.


Foreign exchange risk

When companies conduct business across borders, they must deal in foreign currencies. Companies must exchange foreign currencies for home currencies when dealing with receivables, and vice versa for payables. This is done at the current exchange rate between the two countries. Foreign exchange risk is the risk that the exchange rate will change unfavorably before the currency is exchanged.

One of the more common corporate uses of derivatives is for hedging foreign-currency risk, or foreign-exchange risk, which is the risk that a change in currency exchange rates will adversely impact business results. For example, if the exchange rate increases, then for indirect quotation the volume of export will increase and for direct quotation the volume of export will decrease.

Loss amount faced by the exporters and importers during oil trade because of price and exchange rate volatility.


To analyze exchange rate instability and foreign trade trend of India against United Arab Emirates (UAE).

To analyze the impact of exchange rate instability on India’s trade (export and import) with UAE.

To recommend appropriate hedging tools to avoid foreign exchange risk between India and UAE.

To suggest suitable policy options to the traders and policy makers of both countries.




The exchange rate instability of Indian rupees is examined against the US dollars as the payment terms between India and UAE is US dollars.

The exchange rate instability is analyzed though Moving Average:

As we can see, the Indian Rupees is continuously depreciating in terms of US Dollars. Also, in the years 2011-12, the Indian rupees has fallen sharply with respect to US Dollars because of the Indian economy recession, US Embargo and sanctions on the Iranian oil import and various other reasons. Because of this instability in the exchange rate, there arises the problem of Exchange rate risk wherein the actual value of the contract is very much more than the value decided in the contract. Hence, it leads to abnormal cash out flow to the buyer in the contract. Hence, some hedging tools are needed to protect the buyers and sellers from any such exchange rate stability.

As we can see, the export trend with United Arab of Emirates is increasing over the years. This may be due to the depreciating value of the Indian rupees with respect to the US dollars which leads to a cheaper Export price, hence more exports.

As we can see, the imports of India from United Arab of Emirates are showing an increasing trend and decreasing trend in some years. In year 2011-12, the exchange rate of India depreciated considerably with respect to US Dollars, hence, in those years the imports of India from UAE decreased considerably too, owing to the fact that import price would have increased.

We see that the Imports have been increasing considerably as compared to the exports. This is due to the fact that oil demand is increasing considerably in India; hence, there is a trade deficit being created from 2007-12.


Multiple Linear Regression technique is used to analyze these models using Dynamic modeling, which used lagged variables. That is, the impact of one variable in previous period is observed on the same variable of current period.

Model 1 Analysis: For analyzing the impact of previous years’ export price of India and exchange rate of India on the export value of current year.

Dependent Variable: EXPORTS

Method: Least Squares

Sample (adjusted): 2000M01 2012M09

Included observations: 153 after adjustments



Std. Error

























    Mean dependent var


Adjusted R-squared


    S.D. dependent var


S.E. of regression


    Akaike info criterion


Sum squared resid


    Schwarz criterion


Log likelihood


Hannan-Quinn criter.




    Durbin-Watson stat




As seen in Table, all the signs of the coefficients are theoretically consistent and found statistically significant except exchange rate. As revealed, interestingly the lagged exports of India (of previous month) influenced positively the exports (current period) of India. Also, the exchange rate of India has a positive sign though not significant. Rupee depreciation against US $ (transaction is made in US$) would result positive exports When the export price of Indian goods is less, export would be cheaper in foreign country which will have a positive effect on the exports of India. Therefore, it is positively significant at 1 %. The R square (0.964447) and Adjusted R square (0.963731) values suggest that the model is tightly fit. F statistics shows that model is highly accepted.

Unlike under developed countries like India, the developed countries manage the exchange rate risk by using many instruments such as borrowing or lending in foreign currencies, insurances against exchange risk, the introduction of contractual clauses on the revision of prices and foreign exchange management to even out the timing receipts and payments in foreign currencies and the choice of currency on invoicing, and also hedging operations in their foreign exchange market, which are not available for the developing countries to reduce their or eliminate their exchange rate risk.

Model 2 Analysis: For analyzing the impact of previous years’ import price of India and exchange rate of India on the import value of current year.

Dependent Variable: IMPORTS

Sample (adjusted): 2000M01 2012M09

Included observations: 153 after adjustments



Std. Error

























    Mean dependent var


Adjusted R-squared


    S.D. dependent var


S.E. of regression


    Akaike info criterion


Sum squared resid


    Schwarz criterion


Log likelihood


  Hannan-Quinn criter.




    Durbin-Watson stat




As seen in Table, all the signs of the coefficients are theoretically consistent and found statistically significant except import price variable. If the importer gains more in the previous period, it is expected that importer will import further. Therefore, lagged imports are positively significant at 1%. When the exchange rate against foreign currency depreciates (as the payment is made in US dollars), imports would be affected negatively. Therefore results show that negative sign but not significant. A decrease in import price will have a positive impact on imports. It is revealed from the study that coefficient of import price is not significant. The R square value and F statistics values suggest that the model is tightly fit. F statistics shows that model is highly accepted.


Hedging Techniques for Exchange Rate Risk

As we have seen through data analysis that exchange rate is major factor influencing any trader’s business and can result in losses in the cash flows, hence, exchange rate risk is a major factor and needs to be hedged (minimized to some extent) for exporters and importers both.

Why Hedge Foreign Exchange Risk

For companies, managing the foreign exchange risk seems too complicated, but it is a necessary evil as we have seen through our data analysis, it is expensive and time-consuming. Many do not know about the hedging instruments and techniques that can be used for hedging foreign exchange risk. The companies that do not choose to manage their foreign exchange rate risk through hedging are may be assuming that exchange rates will remain stable or move in the direction that is favorable to any company.

It has been found that managing foreign exchange rate risk successfully reduces the company’s foreign exchange exposure to sudden unfavorable foreign exchange changes. Managing the foreign exchange rate risk provides the following advantages:

• reduces the effects of the sudden unfavorable exchange rate movement on the profits of the company.

• helps in the prediction of the future cash flows.

• eliminates the need for accurately forecasting future directions of the exchange rates.

• facilitates pricing of the products being exported and sold in the international market.

• Temporarily protects the company’s competitiveness.

If any foreign exchange rate risk is able to be reduced at any reasonable cost, then it is accepted that some steps should be taken by company’s managers to apply hedging strategies and protect the companies. The decisions to buy the foreign exchange hedging instruments, is same as the one made when the company decides to buys any other insurance. The insurance, in this case, is the risk of reduction in the cash flows and the profit margins which are caused by the sudden and unfavorable changes in the Indian exchange rate.

Steps in managing foreign exchange exposure

An important ingredient in any fruitful hedging program is that the firm should specify the set of operational goals for those who will be involved in the exchange risk management program. Inability to do this will lead to conflicting and expensive actions on part of the employees. Many firms do have such objectives, but their goals are often very vague, ambiguous and simple so as to provide only a little realistic guidance and approach to the managers. Managers should challenge the dilemma to choose between the two goals of increasing profits and also reducing the exchange losses.

Moreover, decreasing the translation exposure (that is the exposure of negative cash flows when one currency is translated into other currency) could lead to an enhancement in the transaction exposure (that is the exposure of negative cash flows when transaction occurs between foreign traders) and vice versa. What are the tradeoffs that a manager should be willing to make between translation and transaction exposure? The elements for an effective management of foreign exchange rate risk exposure are following:

1. Decide what types of the exposures are to be monitored.

2. Decide upon what are your corporate objectives resolve the potential conflicts in objectives.

3. Make sure that these corporate objectives are in consistence with maximizing the shareholder value and also that they can be implemented.

4. Specify clearly that whoever is responsible for whichever exposures, and list the criterion through which every manager should be judged.

5. Make constraints on the use of various foreign exposure management techniques, like limitations on taking positions in the forward and future contracts.

6. Identify all the channels through which the foreign exchange rate considerations are interlinked with the different operating decisions and which will affect the company’s exchange risk exposure.

Foreign Exchange Risk Management Framework

Once that a firm recognizes its exposure to the foreign exchange rate risk, it can then deploy the resources to help in managing the same. A framework for the firms to manage such risk efficiently and effectively is as follows which can be modified according to the needs of different firm-specific objectives and needs:

Forecasts: When the exposure to foreign exchange rate is determined, first step for the firm is developing a forecast on the trends of the market and the main direction that the trend is going to be regarding the foreign exchange rates. The period for the forecasts is usually 6 months. It is very important that the forecast is based on the valid assumptions. Also after identifying the trends, the probability of the forecast coming as true should also be and also how much the change would be.

Risk Estimation: According to the forecast, Value at Risk must be measured (the actual profit or loss to the portfolio as per the move in the rates as per the forecast) and also the probability of this value at risk has to be determined. The risk that the foreign transaction will fail because of the exchange rate specific problems has to be taken into account also.

Benchmarking: After the exposures estimates and the risk estimates, the firm should set its limits for the handling of the foreign exchange exposure. The firm should also decide whether it has to manage its exposures on the cost centre or the profit centre basis. The cost centre based approach is a defensive approach and its main aim is to ensure that the cash flows of the firm are not affected adversely beyond a particular point. The profit centre based approach is the more aggressive approach wherein the firm has to decide to generate its net profits based on its exposure over the period of time.

Hedging: According to the limits the firm sets for itself so as to manage their exposure, it has to then decide the appropriate strategy of hedging. There are many financial hedging instruments available like: forwards, futures, swaps and options.

Stop Loss: The risk management decisions of the firm are according to the forecasts which are the estimates of the unpredictable trends in the exchange rates. It is important to have arrangements for stop loss so as to rescue firm if any of the forecasts turn out to be wrong. For this purpose, there has to be a certain monitoring system so as to detect the critical levels of the foreign exchange rate for the appropriate measure to be undertaken.

Reporting and Review: The risk management techniques of a firm are subjected to review according to the periodic reporting. The reports largely include profits and loss status of the firm on the contracts that are not closed (open contracts, still remaining open to be completed), after mark to market process, the real exchange rate effect on each exposure and also the profitability as compared to the benchmark and the changes in the overall exposure due to the forecasted exchange rate trends and movements. This review analyses that whether the benchmarks which were set are valid or not and efficient in controlling the exposures or not, what the market direction and trends are and lastly whether the selected strategy is working or not.

Figure for the Framework for Risk Management

Hedging Instruments/Strategies

There are three types of hedges given under the regulation by FASB:

Fair value hedge: It uses derivatives for hedging the changes in fair value of the contract. Fair value is an exit price (the cost of the transaction at the payment time), and not an entry price (the cost of the transaction in the beginning, at the time of signing the contract).

Cash flow hedge: It uses the derivatives for hedging the changes in the future cash flows due to the existing liabilities or assets or forecasted exchange rate transactions.

Net investment hedge: It uses the derivatives for hedging the risks of net investments in any of the foreign operations. For example, net investment hedging is considered to be necessary if any company in India had any subsidiary in U.S., which uses different types of currencies to earn net cash flows. Both, the parent company and the subsidiary company; can use this hedging strategy.

Apart from these hedging strategies, derivatives are also used which are the financial instruments for minimizing the risk of negative cash flows. It is a financial contract/instrument which derives its value from that of some another financial asset, like a commodity price, a stock price, an interest rate, an exchange rate, or index of prices. The role of derivatives is to reallocate risk among the various financial market participants (like hedgers, speculators, arbitrageurs) and help in making the financial markets complete. The various derivative instruments that can be used for hedging the foreign exchange risk are described below:

Forward contract

The forward contract is an agreement between two parties which is customized according to the needs of both the buyer and the seller so as to buy and sell a particular amount (decided upon by both the parties) of a commodity (currency, oil, foreign exchange, index, gold, interest rate, etc) at a particular rate (which is also decided upon by the seller and the buyer) on a specific date in future. The devaluation/depreciation of the currency to be received is hedged against through selling the currency forward contract. If the risk is that the currency will appreciate (that is if the firm has to buy that currency in future time, like for imports), then, it can be hedged by buying the currency forward contract. For example, if Reliance plans to buy the crude oil in US dollars eight months from now, then it can enter into any forward contract to pay in INR terms and buy the US Dollars and lock in the fixed exchange rate of INR-US Dollar that will be paid after 8 months regardless of real INR-USD rate at that time. The real advantage of such a forward contract is that it can be customized according to the particular needs of firm and hence an exact hedge can be attained. The disadvantage is that these contracts are not marketable that is they cannot be sold to any other party if they are no longer required and also they are binding to the original parties to the contract. The obligation of each of the party has to be fulfilled by them.

Futures contract

The futures contract is like a forward contract but it is more liquid because it can be traded in the organized exchanges, that is, the futures market. Devaluation/Depreciation of the currency can also be hedged through selling the futures contract and the currency appreciation can also be hedged through the buying of futures contract. The advantage of the futures contract is that there is the central market for transactions in the futures contract which has eliminated the problems of double coincidence. Future contracts require only a small initial outlay called initial margin which is a proportion of value of future contracts and from this initial outlay significant amounts of money can either be gained or lost with the real forward prices fluctuations. This initial margin system provides a sort of leverage. The previous example for the forward contracts for Reliance can also apply here, just that Reliance will to a US Dollars futures exchange so as to purchase the standardized USD futures contract which is equal to the amount that is to be hedged as there is the risk that US Dollar may appreciate with respect to the Indian Rupees. Also, the futures contract can’t be tailored according to the needs and requirements of the seller and the buyer, that is, only specific and standard denominations of the money can be bought and not the exact amounts that can be bought in the forward contract.

Options contract

An Option contract is a contract which gives the right, but not the obligation, to the buyer of the option contract to buy or sell a particular quantity of a foreign currency in the exchange for another currency at a particular fixed price which is called the Exercise Price or the Strike Price. The fixed nature of such an exercise price decreases the uncertainty of the exchange rate variations and also limits the losses of the buyer/seller in their open currency contract positions. These contracts are specifically suited for the hedging of continuous cash flows, as in the case of the bidding. There are two types of option contracts available: CALL AND PUT OPTIONS.

Call Options: these option contracts are used if the risk is an appreciating trend of the price (that is of the currency). In this contract the buyer of the call option has the right but not the obligation to buy a particular quantity of the underlying asset (currency in this case). The option writer or the option seller has an obligation to sell the underlying asset to the buyer if the buyer decides to fulfill the contract. For this service, the writer charges an amount known as option premium from the option buyer/holder. If the exercise price is less than the market price then the holder of the option contract will decide to fulfill the contract as it will lead to positive cash flows for him. Similarly, if the market price is less than the strike price then the option holder will not execute the contract as it will lead to negative cash flows for him. In such contracts, the profits to the option holder are unlimited and the losses to the option writer are unlimited and his profits are limited to the extent of the option premium.

Put Options: These contracts are used if there is the risk of a decreasing trend. In this contract the buyer of the call option has the right but not the obligation to sell a particular quantity of the underlying asset (currency in this case). The option writer or the option seller has an obligation to buy the underlying asset from the buyer if the buyer decides to execute the contract. For this service, the writer charges an amount known as option premium from the option buyer/holder. If the exercise price is more than the market price then the holder of the option contract will decide to execute the contract as it will lead to positive cash flows for him. Similarly, if the market price is more than the strike price then the option holder will not execute the contract as it will lead to negative cash flows for him. In such contracts, the profits to the option holder are unlimited and the losses to the option writer are unlimited and his profits are limited to the extent of the option premium.

Again taking the example of Reliance, which has to purchase crude oil in US Dollars in 8 months, if the Reliance buys a Call option (as the risk is of an appreciating trend in the US dollar rate), that is, the right to buy a particular amount of US dollars at fixed rate on a particular date, there are 2 scenarios in this case. If the exchange rate movement will be favorable, that is, the US dollar devaluates/depreciates with respect to the Indian rupees, then, the Reliance will buy US Dollars at the market rate as they are now cheaper. In the second case, if the US dollar is appreciating with respect to the Indian Rupees as compared to today’s market rate, then, Reliance will exercise the option contract to purchase US dollars at the agreed exercise price. In both cases Reliance will benefit from the payment of the lower price so as to purchase the US Dollar.

Swaps Contract

The swap contract is the foreign currency contract wherein the buyer and seller will exchange the equal initial principal amounts of the two different currencies at the market (spot) rate. Both the parties will exchange fixed or floating rate of interest rate payments in their respective currencies over the period of the contract. At maturity of the contract, the principal amount is again re-swapped at the pre-determined exchange rate so that both the parties will end up with the original currencies only. The advantage of swap contracts is that the firms with only a limited appetite for the exchange rate risk may move in the direction of a partially or completely hedged position by this mechanism of the foreign

Currency swaps, leaving their underlying borrowing transaction intact. Also, apart from this, swap also allows the firm to hedge their floating interest rates risk. For example, there is an exporting company that has entered into a swap contract with other firm for a principal amount of 1 million US Dollars at the exchange rate of Rs.42/dollar. The company will pay 8 months US LIBOR to a bank and will receive 12.00% p.a. every 8 months on 1st of January and till 1st September, till 2 years. Such a company would earn in US Dollars and can also use the same amount to pay the interest for such a kind of borrowing (in US Dollars instead of Rupees) and thus hedging its foreign exchange rate exposures.


Findings and Suggestions

After analyzing the effects of the exchange rate fluctuations on the exports and imports of India to and from the United Arab of Emirates, we see that as the exchange rate of Indian Rupees depreciated with respect to the US Dollars, the export price becomes cheaper and the import price becomes expensive. Hence, when India is exporting there are no considerable earnings of the foreign reserves of US dollars. And when India is importing, there is a considerable out flow of the foreign reserves of US Dollars. This creates a trade deficit as India has to import Crude oil for meeting its various demands and needs of the citizens.

Major Findings:

From the study, the obtained major findings are as follows:

The moving average analysis of the exchange rate gives the depreciating trend, that is, the Indian rupees is depreciating with respect to the US Dollars over the study period (December 1999 to September 2012).

The moving average analysis of exports value of India gives the result that the exports of India are increasing, but not considerably. The exchange rate of India is depreciating, hence the export price is becoming cheap, therefore, the exports of India are increasing.

The moving average analysis of imports value of India gives that the imports are increasing considerably. The import price is expensive due to the depreciating exchange rate of India vs. US Dollars. But, as the oil demand is still there, hence, India imports from UAE are increasing.

There is a trade deficit from year 2007-12 due to the increase in the imports and decrease in the exports of India from and to UAE.

The multiple linear regression dynamic analysis reveals that the exports of India to UAE are highly dependent on the exchange rate of previous month and the export price of previous month.

The multiple linear regression dynamic analysis reveals that the imports of India from UAE are highly dependent on the exchange rate of previous month and the import price of previous month.


Hence, the various recommendations and suggestions to the Indian traders are as follows so as to reduce their exposure to the foreign exchange rate risk:

The Indian companies should have a proper risk management framework integrated into their daily operations and also aligned with their corporate strategies and corporate goals, aims and objectives.

The companies should have an internal management system that can keep a check on the various international trade and dealings.

The company should set a Value-at-Risk (VAR) limit on all the positions of the contracts in their portfolio. And, if any VAR limit is crossed, then serious disciplinary action needs to be taken against such person(s).

The traders should make use of the various hedging strategies and techniques available in the financial market. They should use either forward contracts or future contracts or swap contracts or option contracts according to their needs and requirements.

There should be a reporting culture in the company. As soon as any employee enters into any international trade contract, then proper logging of the transaction must be done and proper tracking of the log should be done so as to analyze any unfavorable market movements that can result in negative cash flows. The same must be reported to the senior manager so that he/she can also track the performance of the contract in the financial market.

Before entering into any international trade contract, the previous history and the credibility of the opposite party must be verified so as to protect one from any payment faults.

If any company in entering into a future contract, then the initial margin and the mark-to-market positions must be verified daily so that if there are any losses then those can be covered by entering into other profitable contracts.

The policies and the regulations that are given by your country’s government must be followed at all times while entering into any contract and also while applying hedging strategies and techniques.

Proper analysis of the previous trends of the exchange rate performance and of the export and import prices must be done, so as to predict future trends of these and therefore one can take precautionary actions by entering to profitable contracts and by applying hedging techniques and strategies.

The hedging techniques and strategies must be applied with considerable precautions as the derivatives are leveraged products and hence can create a false sense of safety. The positions in each of the hedging contracts in the company’s portfolio must be examined daily so as to see that no contract is leading to a negative cash flow.


Our Service Portfolio


Want To Place An Order Quickly?

Then shoot us a message on Whatsapp, WeChat or Gmail. We are available 24/7 to assist you.


Do not panic, you are at the right place


Visit Our essay writting help page to get all the details and guidence on availing our assiatance service.

Get 20% Discount, Now
£19 £14/ Per Page
14 days delivery time

Our writting assistance service is undoubtedly one of the most affordable writting assistance services and we have highly qualified professionls to help you with your work. So what are you waiting for, click below to order now.

Get An Instant Quote


Our experts are ready to assist you, call us to get a free quote or order now to get succeed in your academics writing.

Get a Free Quote Order Now