35  Foreign exchange market; Exchange rate risk and hedging techniques

35.1 Concept of the Foreign Exchange Market

The foreign exchange (FX or forex) market is the largest and most liquid market in the world — a 24-hour, decentralised, over-the-counter (OTC) market in which currencies are traded across financial centres. According to the BIS Triennial Survey, daily global forex turnover exceeds USD 7 trillion. Participants include central banks, commercial and investment banks, corporates, hedge funds, retail brokers and individuals. The market exists because international trade, investment and capital flows require currency conversion, and because exchange-rate risk must be managed.

35.2 Functions of the Forex Market

TipThree Functions
  • Transfer of purchasing power — across countries via currency conversion.
  • Provision of credit — short-term financing for international trade.
  • Provision of hedging facilities — to manage exchange-rate risk via forwards, futures, options, swaps.

35.3 Participants

TipMajor Participants
  • Commercial banks — largest dealers; interbank market.
  • Central banks — intervene to manage exchange rates; manage reserves.
  • Corporates — for trade payment, hedging, FDI.
  • Investment banks and hedge funds — speculation, arbitrage.
  • Forex brokers — intermediaries.
  • Retail individuals — through brokers.

35.4 Types of Forex Markets

TipForex Market Segments
Segment Working content
Spot market Immediate delivery (T+2 typically)
Forward market Customised OTC contracts for future delivery
Futures market Standardised exchange-traded contracts
Options market Right but not obligation to buy/sell
Swap market Exchange of cash flows in two currencies

35.5 Quotation of Exchange Rates

TipForex Quotation Conventions
Convention Example Meaning
Direct quote INR 83 / USD Home currency per unit foreign currency
Indirect quote USD 0.012 / INR Foreign currency per unit home currency
Bid-Ask spread 83.20 / 83.25 Buy / sell quote; dealer’s profit
Cross rate USD-EUR via INR Two non-USD rates derived through the USD

In India, RBI publishes the reference rate daily based on a weighted average of bank quotes.

35.6 Spot, Forward, Premium and Discount

If forward rate > spot rate, the foreign currency is at a forward premium; if forward < spot, at a forward discount.

\[\text{Annualised Forward Premium / Discount} = \frac{F - S}{S} \times \frac{12}{n} \times 100\]

where n = forward period in months.

35.7 Parity Conditions in International Finance

TipKey Parity Conditions
Condition Statement
Purchasing Power Parity (PPP) \(S_{H/F} = P_H / P_F\) — Cassel (1918); says exchange rate adjusts to equalise purchasing power
Interest Rate Parity (IRP) \((F - S)/S = (i_H - i_F)/(1 + i_F)\) — no-arbitrage between forward and spot
International Fisher Effect Currency with higher nominal interest rate will depreciate
Fisher Effect Nominal rate = Real rate + Expected inflation
Unbiased Forward Expectations Forward rate is the unbiased predictor of future spot

35.7.1 Big Mac Index

Coined by The Economist (1986), the Big Mac Index is an informal PPP gauge — the relative price of a Big Mac across countries indicates currency over/under-valuation.

35.8 Exchange Rate Risk

Exchange rate risk (FX risk) is the risk that changes in exchange rates will adversely affect cash flows or accounting values.

TipThree Types of FX Exposure
Type Working content
Transaction exposure Effect of FX changes on cash flows of known foreign-currency obligations (receivables, payables)
Translation (accounting) exposure Effect on consolidated financial statements when foreign-currency subsidiaries are translated
Economic / Operating exposure Effect on future cash flows and competitive position due to exchange-rate changes

35.9 Hedging Techniques

35.9.1 Internal (Natural) Hedging

TipInternal Hedges
  • Invoicing in home currency — push risk onto counterparty.
  • Leading and lagging — accelerate (lead) or delay (lag) FX cash flows.
  • Netting — within group, offset opposite exposures.
  • Matching — match foreign-currency assets and liabilities.
  • Price adjustment clauses in contracts.
  • Natural hedge through operations — manufacture or borrow in same currency as receivables.

35.9.2 External Hedging — Derivatives

TipExternal Hedges with Derivatives
Instrument Working content Pros Cons
Forward contract Customised OTC agreement to buy/sell currency at future date at agreed rate Customised; no upfront cost Counterparty risk; cannot benefit from favourable moves
Currency futures Standardised exchange-traded contract Liquid; central-counterparty Standard sizes; daily mark-to-market margin
Currency options Right (not obligation) to buy (call) or sell (put) at strike Asymmetric — keep upside Premium cost
Currency swap Exchange of principal and interest in two currencies Long-term; reduces costs Complex
Money-market hedge Borrow/lend in money markets to lock in FX rate Replicates forward; uses available instruments Cash-flow timing

35.9.3 Indian Hedging Framework

TipIndian Forex Hedging Landscape
  • RBI — regulator; FEMA 1999.
  • OTC forwards — via authorised dealers (banks).
  • Currency futures — on NSE, BSE, MSE since 2008-09; standardised contracts on USD/INR, EUR/INR, GBP/INR, JPY/INR.
  • Currency options — on stock exchanges since 2010-11.
  • Cross-currency derivatives — permitted in stages.
  • Hedging limit — earlier limits relaxed for genuine underlying exposure; OTC and exchange-traded both available.

flowchart TB
  EX[FX Exposure] --> T[Transaction]
  EX --> TR[Translation]
  EX --> EC[Economic / Operating]
  H[Hedging] --> IN[Internal: invoicing, leading-lagging, netting, matching]
  H --> ET[External: Forward, Futures, Options, Swap, Money-market]
    classDef default fill:#003366,color:#ffffff,stroke:#ffcc00,stroke-width:3px,rx:10px,ry:10px;

35.10 Practice Questions

Q 01 Forex Easy

The world's largest financial market by daily turnover is the:

  • AStock market
  • BBond market
  • CForeign exchange market
  • DCommodity market
View solution
Correct Option: C
Forex — > **USD 7 trillion** daily (BIS Triennial Survey).
Q 02 Quote Easy

A *direct quote* in Mumbai is:

  • AUSD 0.012 / INR
  • BINR 83 / USD
  • CINR 1 / GBP
  • DUSD 1 / USD
View solution
Correct Option: B
Direct = **home currency per unit foreign** = INR/USD in India.
Q 03 PPP Medium

Purchasing Power Parity (PPP) was formalised by:

  • AGustav Cassel (1918)
  • BFisher
  • CMundell
  • DKeynes
View solution
Correct Option: A
**Gustav Cassel (1918)** — PPP.
Q 04 Exposure Medium

An Indian importer has agreed to pay USD 1 million in 90 days. This is which type of FX exposure?

  • ATranslation exposure
  • BTransaction exposure
  • CEconomic exposure
  • DCountry exposure
View solution
Correct Option: B
**Transaction** — known FX obligation in the future.
Q 05 Translation Medium

**Translation exposure** arises when:

  • ACash receivables are due in foreign currency
  • BForeign-currency subsidiaries are translated into home currency for reporting
  • CCompetitor's prices change
  • DGoods are exported
View solution
Correct Option: B
Translation = accounting/conversion exposure on consolidation.
Q 06 Forward Medium

The spot rate is INR 83/USD; 3-month forward rate is INR 84/USD. USD is at:

  • AForward discount
  • BForward premium
  • CCross rate
  • DBid-ask spread
View solution
Correct Option: B
F > S ⇒ USD at **forward premium** against INR (INR at forward discount against USD).
Q 07 Cross Medium

If INR/USD = 83 and EUR/USD = 0.92, the INR/EUR cross rate ≈:

  • A76.36
  • B83.92
  • C90.22
  • D75.00
View solution
Correct Option: C
INR/EUR = (INR/USD) ÷ (EUR/USD) = 83 ÷ 0.92 ≈ **90.22**.
Q 08 Hedging Medium

Which is **not** an internal hedge?

  • AInvoicing in home currency
  • BLeading and lagging
  • CNetting
  • DForward contract
View solution
Correct Option: D
Forward contract is an **external** (derivative) hedge.
Q 09 Option Medium

A currency option provides:

  • AAn obligation to buy at the agreed rate
  • BThe right but not obligation to buy or sell
  • CA swap of cash flows
  • DA loan
View solution
Correct Option: B
**Option = right, not obligation**, in return for a premium.
Q 10 India futures Medium

Currency futures in INR were launched on Indian stock exchanges in:

  • A2001
  • B2005
  • C2008-09
  • D2015
View solution
Correct Option: C
**Currency futures (USD/INR) — 2008-09** on NSE / BSE; options 2010-11.
Q 11 Spot Easy

Standard *spot* settlement in the forex market is typically:

  • AT + 0
  • BT + 1
  • CT + 2
  • DT + 30
View solution
Correct Option: C
Spot is **T+2** in most major pairs.
Q 12 IRP Hard

Interest Rate Parity (IRP) implies:

  • AForward premium ≈ interest-rate differential
  • BSpot rate = Forward rate
  • CInflation is the same across countries
  • DBig Mac index is irrelevant
View solution
Correct Option: A
(F − S)/S ≈ (i_H − i_F)/(1 + i_F) — no-arbitrage condition.
Q 13 Match Medium

Match each parity with its statement:

Parity Statement
(i) PPP (a) Forward rate is unbiased predictor of future spot
(ii) IRP (b) Currency with higher nominal interest depreciates
(iii) International Fisher (c) Exchange rate adjusts to equalise purchasing power
(iv) Unbiased Forward (d) Forward premium = interest-rate differential
  • A(i)-(c), (ii)-(d), (iii)-(b), (iv)-(a)
  • B(i)-(a), (ii)-(b), (iii)-(c), (iv)-(d)
  • C(i)-(b), (ii)-(c), (iii)-(d), (iv)-(a)
  • D(i)-(d), (ii)-(a), (iii)-(b), (iv)-(c)
View solution
Correct Option: A
PPP — purchasing power; IRP — interest differential; IFE — high nominal depreciates; Unbiased Forward — F as predictor.
Q 14 Big Mac Medium

The Big Mac Index is an informal indicator of:

  • AInflation
  • BPurchasing Power Parity
  • CForward rate
  • DInterest rate
View solution
Correct Option: B
*The Economist*'s Big Mac Index — informal PPP gauge since 1986.
Q 15 Swap Medium

A *currency swap* involves:

  • AExchange of principal and/or interest in two currencies
  • BBuying foreign currency at spot
  • CRight to buy a currency
  • DStandardised futures
View solution
Correct Option: A
Currency swap — exchange of cash flows in two currencies.
Q 16 Forward calc Hard

Spot 80; 6-month forward 82. Annualised forward premium:

  • A2.5 %
  • B5 %
  • C10 %
  • D12 %
View solution
Correct Option: B
(82 − 80)/80 × 12/6 × 100 = 2.5 × 2 = **5 %**.
Q 17 Money market hedge Hard

A money-market hedge replicates the outcome of a:

  • AForward contract
  • BCall option
  • CPut option
  • DSwap
View solution
Correct Option: A
Money-market hedge — borrow/lend in the two currencies to lock in the implied forward rate.
Q 18 Exposure Hard

A long-term effect of FX changes on a firm's **competitive position** is:

  • ATransaction exposure
  • BTranslation exposure
  • CEconomic / Operating exposure
  • DSettlement exposure
View solution
Correct Option: C
**Economic exposure** — long-run competitive / cash-flow effect.
Q 19 Authorised Medium

Forward contracts in INR can be transacted through:

  • ARBI directly
  • BAuthorised Dealer (AD) banks under FEMA
  • CSEBI
  • DPost Office
View solution
Correct Option: B
**AD banks** licensed under FEMA execute forex contracts.
Q 20 Netting Medium

An MNC group with a subsidiary owing USD 5 million to another offsets the exposure internally. This is called:

  • ANetting
  • BHedging via futures
  • CPredatory pricing
  • DArbitrage
View solution
Correct Option: A
**Netting** — offsetting opposite FX positions within a group; reduces external hedging need.

35.11 Quick Recall

ImportantQuick recall
  • Forex market — largest, 24-hr OTC; > USD 7 trillion/day (BIS).
  • Three functions: transfer purchasing power, credit, hedging.
  • Segments: spot (T+2), forward, futures, options, swaps.
  • Quotation: direct (home/foreign), indirect, bid-ask, cross rate.
  • Forward premium/discount: F > S — premium; annualised = (F − S)/S × 12/n × 100.
  • Parity: PPP (Cassel 1918), IRP (no-arbitrage), International Fisher, Unbiased Forward Expectations.
  • Three exposures: Transaction (known FC cash flows), Translation (consolidation), Economic / Operating (long-run competitive).
  • Hedging: Internal (home-currency invoicing, leading/lagging, netting, matching) vs External (forward, futures, options, swap, money-market).
  • India: AD banks under FEMA; currency futures since 2008-09; options since 2010-11.