Page 101 - DMGT549_INTERNATIONAL_FINANCIAL_MANAGEMENT

International Financial Management

Notes option receives premium. The option premium depends on the strike price, the maturity
date, current spot rate and the volatility.
For example, a customer having a liability in Euro with a view that the Euro/USD rate
will be higher on maturity date will buy an Euro call. On the maturity date, he has the
option to buy the Euro at the strike price or buy it from the market in case it is cheaper.
If the customer buys a Call Option with a strike price at 0.9000 and on maturity date, the
rate is 0.8700, the customer has the right to exercise the option. Since in the example cited,
it would be cheaper for the customer to by the Euro from the market, the customer will not
exercise the option.
There are various structures available in the option market and the more frequently used
ones are the Vanilla Options-structures with Knock In and Knock Out structures, Forward
Extras, Range Forwards.
4. Currency Swap: A currency swap is defined as an agreement where two parties exchange
a series of cash flows in one currency for a series of cash flows in another currency, at
agreed intervals over an agreed period. Typically, a corporate would want to do such a
swap if it wants to convert its liabilities in a particular currency to that of another currency.
For example, U.S. corporate needs German Marks to fund a construction project in Germany.
The company chooses to issue a fixed rate bond in dollars and convert them to German
Marks. The company takes the dollars received from the issue of the dollar denominated
bond and pays them up front to a swap dealer who pays a certain amount of Marks to the
firm. Interest payments on the dollar denominated bond are paid in dollars. At the same
time, the firm pays an agreed-upon amount of German Marks to the swap dealer and
receives dollars in exchange. The dollars received from the swap dealer offset the payment
of the dollar coupon interest. Upon maturity, the firm pays its bondholders in dollars and
receives an equivalent amount of dollars from the swap dealer to which it paid an agreed-
upon amount of Marks. In effect, the company has converted its Dollar denominated loan
into a Mark denominated loan.
The most popular instrument used to hedge are forward exchange contracts in India. Although
in the more developed markets, options and derivatives are used to a larger extent. Forward
contracts are more popular for the following reasons:
1. Forward exchange markets are well established and transparent.
2. Forward contracts are accessible even by the smaller corporates. There are few corporates
in the country who have volumes which are tradeable in the option and derivative markets.
3. Many corporate policies do not allow them to trade in options and derivatives. This is
because these instruments are perceived to be risky and expensive. Options are relatively
new to the Indian market. There is also a lack of product knowledge. Hence, many corporates
are not too comfortable while dealing with options.
6.4.1 Market Imperfections/Inefficiencies that Characterize the Indian
Markets for these Instruments

Inefficiencies in the Indian market for foreign exchange, option and derivatives can be enumerated
as follows:
1. The Indian foreign exchange market is monitored and regulated by the Reserve Bank of
India. In most developed financial markets, the intervention by means regulation in the
financial markets is extremely low. At times of this prevents the markets from adjusting
itself to reflect the true demand/supply mismatch and also leads to a lot of uncertainty
amongst the market participants.

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