Reasons of utilizing Indian rupee and British pound The Indian rupee's strike point proceeds for the second day straight in seven days. Rupee hit a substitution record low of 70.32 against a British pound after prior breaking 69.80 levels inside the given time. The homegrown unit shut down at 69.89 versus British Pound currency. i. British pound index hits 13-month high: The British pound list, which gauges the strength of British pound against a container of six significant monetary standards, arrived at a more than 13-month elevated level of 96.984. In any case, in exchange today it again flooded by 0.1% at 96.756. Critical strength inside the British pound according to one among the main business dailies report is particularly on the back of most recent public exchanging strategy (Haushalter, 2000). ii. Newly set off interest for haven currencies in the midst of cash war: Additionally, the current drop out of developing business sector monetary forms including Indian rupee has prompted an expanded interest for shelter monetary forms like British pound, and pound as foreign investors are utilizing them to hedge their positions in Indian resources (Carter, Pantzalis & Simkins, 2001). iii. FII capital outflow: FIIs had net sold value worth INR 1,100.20 crore according to the temporary information with the stock trades. Notably during the period, homegrown institutional speculators or DIIs (domestic institutional investors) got an inflow of INR. 93.64 crore into the capital markets (Mohanty, 2002). iv. Trade deficit weakness: Additionally, Indian rupees free fall has been set off on the back of augmenting trade deficit which for the July month has ascended to a more than 5-year elevated level of $18 billion gratitude to extending oil import bill likewise as an ascent in import of gold by practically 41%. GBP theoretical net positions: A. GBP/INR: The pound stayed close to three-week highs against the Indian Rupee, as theory the Federal Reserve System will intend to keep up the degree of its month to month resource buys for the nonce kept on burdening the greenback. We anticipate that GBP should exchange solid against the INR and USD. The GBP/INR is exchanging close to cost of 100.25. The pair is likely going to ascend to 100.68 levels. B. EUR/INR: The EUR fell against the INR; be that as it may, misfortunes were covered after EURUSD pair rose to close fourteen-day elevated levels during the ecu meeting. The euro zone's exchange excess broadened more-than-anticipated. the current record excess limited to an overflow of 13.7 billion Euros ($18.5 billion), following an upwardly updated EUR17.9 billion excess. EU development yield is most likely going to have insignificant effect on the EUR/USD pair. Generally speaking, the standpoint for the EUR/INR remains bearish. The pair is presumably going to check 83.50 levels. (Investing.com, sd) Interest rate Risk Loans have a fixed interest rate of repayment. The risk associated with this rate is where the value of the loan amount declines with the increasing interest rate (Oberoi, 2018). When the interest rate increase, the investors will be required to repay more in addition to the principal amount. The rise in long-term interest rate renders the required rate of return by the banker to increase, making the loans more expensive. The current value of loan therefore declines with the increasing interest rtes. The risk is more prominent for fixed rates rather than floating rates because as the loan amount remain fixed even when the economy demands a rise in the interest rates. From the case study, the interest rate risk is negligible since the applicable rates have been stable over the years. The interest rates charged in UK is averaging at 1.8%. The loaning takes place in UK banks and hedge in Indian rupees which charges interest rate of 9.3% (The world bank, n.d). Exchange rate risk Usually, this risk occurs when the currency of investing decline against the currency of loaning (Beckmann, & Stix, 2015). An example is when the investor loan money in euros and invest in Indian rupee. When the value of Indian rupee declines against the value of euro, the investor will be expose to exchange rate risk. From the case given, there is exchange rate risk in GBP to INR, where the rate is 99.60, whereas the value of Euro to Indian rupee declines to 89.44. In simple terms, when the investor translates back the investing currency to loaning currency, he/she will receive less than the actual amount borrowed. The expected gains from investment will be smaller when converted to the loaning currency even if the proceeds of investment are positive. In general, the depreciation of invested currency leads to decline in the value of investment and when the investor translates the investment into the borrowing currency, the value received will be less, leading to loss on the part of investor. (The world bank, n.d). Other risks i. Liquidity risk Liquidity is the ability to convert an asset into ready cash. According to Kondor and Vayanos (2019), when the investor loan some amount to buy bonds for example, the uncertainties in market may necessitate him/her to sell the asset. If the money market is inactive, the investor will be forced to sale the asset at a lower price, giving rise to loss. The aim of selling below bar is to attract buyers to generate cash faster. ii. Credit risk The credit risk occurs where there is a lot of uncertainties of recollection of loan amount (Bluhm, Overbeck, & Wagner, 2016). When an investor wants to invest in a volatile market with credit uncertainties, the bank may require him/her to acquire the loan at a premium. This increase the cost of loan. On the other hand, the sale of investment assets such as bonds may require the investor to quote a lower price to compensate potential buyers for the credit risk in the market. The proceeds of investment will be reduced whereas cost of loan is increased. Hedging of Foreign Currency Scenario one: In this scenario, money market technique will be used to carry out the hedging for transaction exposure. If a foreign currency receivable is expected at a specific time and the currency risk wants be hedged via the money market (Metadjer, & Moloney, 2017), the following steps will have to be followed: 1. Borrow the foreign currency in amount equivalent to the present value of the receivable 2. Convert into domestic currency at the spot rate 3. Place the domestic currency on deposit at the prevailing interest rate 4. When foreign currency receivable comes in repay loan plus the interest rate. Amount received in foreign currency. Borrow the present value of receivables 1euro= GBP 0.8936 (Foreigncurrencydirect, n.d.) =2,000,000 X 0.8936 =£1,787,200 𝐹𝑣 Pv= (1+𝑟)𝑛 = 1,787,200 (1.018)5 =GBP1,720,777.97 Taking INR as home currency, the equivalent amount in home currency will be; 1 GBP = INR 99.60 (Foreigncurrencydirect, n.d.) =1,720,777.97X 99.60 = INR 171,389,485.80 1 euro = INR 89.440 (Foreigncurrencydirect, n.d.) = 171,389,485.80 171,389,485.80 = 89.44 =€1,916,250.96 The repayment amount will include interest of 1.8% as follows =1,787,200 X 1.018^5 = GBP 1,953,943.70 But; 1GBP= Euro 1.11038 (5-year forecast) (Walletinvestor, 2021) =1,953,943.70 X 1.11038 =€2,169,620,01 There will be a loss of €253,369.05 (€1,916,250.96-€2,169,620,01) from this hedge. Scenario Two: In this scenario, the British pound will be a base currency and cash flows will be received in this currency. However, the repayment will be in euros. Similar to scenario one, the applicable technique is money market and there is a need to adjust the present value of the loaned amount into the expected future amount (Pellegrini, Meoli, & Urga, 2017). The interest rate will be 1.8% for a period of 5 years (The world bank, n.d). The hedge will be offer the investor from the following calculation If the loaned amount was to be invested in British pound I£= €1.11256 (Foreigncurrencydirect, n.d.) But in future, the value will be; 𝐹𝑣 Pv= (1+𝑟)𝑛 2,000,000 = 1.11256 =1,797,655.86 The borrowed amount will be invested in Indian rupees and translation will be as follows 1£ = INR 99.60 £1,797,655.85= =1,797,655.85 X 99.60 = INR 179,046,522.90 However, the invested amount needs to be repaid in euro to the bank and this is where the hedge will result in either gain or loss as shown below; 1 euro= INR89.440 =179,046,522.90 179,046,522.90 = 89.44 𝑋1 =Euro 2,001,861.84 But since the banks charges interest, the loaned amount will be repaid with 1.8% interest. The total amount therefore will be; £1,797,655.85 X (1+0.018)^5 =£1,965,374.14 But the repayment currency was Euro, therefore the repaid will be equivalent as computed below I£= 1.11038 (5-year forecast) (Walletinvestor, 2021) =£1,965,374.14 X 1.11038 = Euro 2,182,312.14 From the calculation above, the amount realized from this hedge will be less than the borrowed amount. The loss will be equivalent to €180,450.30 (2,001,861.84-2,182,312.14). Scenario Three: If the company expect maturity of investment in five years, then the forward contract hedge can be applied to the investment. This hedging technique helps financial firm and corporates to protect themselves from currency market volatility by fixing the exchange rate over a set of a period on a predetermined amount of currency (Wong, 2013). It allows the form to lock a specific currency thereby hedging payable denominated in that currency. A forward contract is negotiated between the firm and the financial institution. In this scenario, the contract specifies the following, 1. The currency the firm will pay, in this case, it will in British pound 2. The Currency the firm will receive, for this scenario, it will be received in rupees 3.The exchange rate, that is 1.11236 5. Future date which the exchange of currencies will occur that is 5 years The amount received is €2million, taking British as home currency (buying currency), 1£ = €1.11236 (Foreigncurrencydirect, n.d.) =€2,000,000 2000000 = 1.11236 =£1,797,979.07 Suppose the buying currency is Indian rupee; 1£ = INR 99.60 £1,797,979.07= 1,797,979.07 𝑋 99.60 = 1 =INR 179,078,715.40 But; 1 euro = INR 89.440 (Foreigncurrencydirect, n.d.) =INR 179,078,715.40 179,078,715.40 = 89.440 𝑋1 =€2,002,221.77 When repaid, the investor will incur interest rate of 1.8% =1,797,979.07 X 1.018^5 =£1,965,728.44 But; 1 GBP= Euro 1.11236 =£1,965,728.44 X 1.11236 =€2,186,597.69 The hedge will result in a loss of €184,376 (€2,186,597.69-2,002,221.77). Recommendation The hedging from the above calculation offer the investors with different returns. In some occasion, the investor will incur losses from the act and as such, such hedges should be avoided. The following recommendation refers to the investment hedge calculated from the three scenarios above; i. The investor should avoid the hedge. The investments will lead to a loss. The volatility present in the Indian rupee contributes to exchange rate risk which expose the investment into potential losses. The liquidity risk in the Indian market also will require the investor to sell the investment at a lower rate, resulting in a loss. ii. The investor should consider call option hedge as this possess a potential of realizing profits. The call option hedge might be less volatile and more liquid hence the credit risk is negligible. The exchange rate with British pound increases in value, hence increasing the value of investment. In this way, the exchange rate risk will be avoided. References Beckmann, E., & Stix, H. (2015). Foreign currency borrowing and knowledge about exchange rate risk. Journal of Economic Behavior & Organization, 112, 1-16. Bluhm, C., Overbeck, L., & Wagner, C. (2016). Introduction to credit risk modeling. Crc Press. Carter, D.A., Pantzalis, C., Simkins, B.J. (2001). Firmwide risk management of foreign exchange exposure by US multinational corporations. Working Paper, Oklahoma State University. Foreigncurrencydirect, (n.d.) Live Foreign Exchange Rates - Currency Exchange Rate. https://www.currencies.co.uk/live-exchangerates/ Haushalter, G.D. (2000). Financing policy, basis risk, and corporate hedging: Evidence from oil and gas producers. The Journal of Finance, 55(1), 107–152. Investing.com. (sd). GBP/INR - British Pound Indian Rupee. Retrieved from: https://www.investing.com/currencies/gbp-inr Kondor, P., & Vayanos, D. (2019). Liquidity risk and the dynamics of arbitrage capital. The Journal of Finance, 74(3), 1139-1173. Metadjer, N., & Moloney, K. (2017). Liquidity Analysis of Bond and Money Market Funds. Central Bank of Ireland Economic Letter, 2017(17). Mohanty, P. (2002). Evidence of size effect on stock returns in India. Vikalpa, 27(3), 27–37. Oberoi, J. (2018). Interest rate risk management and the mix of fixed and floating rate debt. Journal of Banking & Finance, 86, 70-86. Pellegrini, C. B., Meoli, M., & Urga, G. (2017). Money market funds, shadow banking and systemic risk in United Kingdom. Finance Research Letters, 21, 163-171. The world bank, (n.d) Lending interest https://data.worldbank.org/indicator/FR.INR.LEND Walletinvestor. (2021). EUR TO GBP FORECAST. Retrieved from: https://walletinvestor.com/forex-forecast/eur-gpb-prediction rate (%) Wong, K. P. (2013). Cross hedging with currency forward contracts. Journal of Futures Markets, 33(7), 653-674.
