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ADRRI JOURNAL (www.adrri.org) pISSN: 2343-6662 ISSN-L: 2343-6662 VOL. 3 ,No.3, pp 38-51,December, 2013 Comparative Analysis of Foreign Exchange Risk Management Practices among Non Banking Companies in India Anupam Mitra Associate Professor, SIBM, Bengaluru, Symbiosis International University, Email: anupammitra13@gmail.com
Received: 29th October, 2013 Accepted: 30th November, 2013 Published Online: 1st December, 2013

URL: http://www.adrri.org/journal

Abstract
Foreign exchange rate risk in general is related to unexpected changes in foreign exchange rates. The importance of managing foreign exchange risk has increased with a global economic and financial integration, and the associated increase in global trade, liberalization of financial markets, and dismantling of capital controls. There are no exchange-traded currency derivatives in India. In terms of the growth of derivatives markets, and the variety of derivatives users, the Indian market has equaled or exceeded many other regional markets. While the growth is being spearheaded mainly by private sector institutions and large corporations, smaller companies and state-owned institutions are gradually getting into the act. This paper has tried to examine prior research on foreign exchange exposure and the use of operational and financial hedging to manage foreign exchange exposure by Indian Companies. Further this paper has attempted to examine Indian companies foreign exchange risk management practices. This paper has also tried and present some of the main issues in the measurement and management of exchange rate risks faced by companies, with particular

AFRICA DEVELOPMENT AND RESOURCES RESEARCH INSTITUTE (ADRRI) JOURNAL ADRRI JOURNAL (www.adrri.org) pISSN: 2343-6662 ISSN-L: 2343-6662 VOL. 3 ,No.3, pp 38-51,December, 2013 attention to the traditional types of exchange rate risk (transaction, translation, and economic), and the advantages and disadvantages of various exchange rate risk management approaches (tactical vs. strategic, passive vs. active). It has also tried to outline a set of widely accepted best practices in currency risk management, and review the use of some of the widely used hedging instruments in the OTC and exchange traded markets.

Keywords: Foreign Exchange Risk, Non-banking Companies, India

INTRODUCTION "You cannot discover new oceans unless you have the courage to lose sight of the shore" The etymology of the word Risk can be traced to the Latin word Rescum, meaning Risk at Sea or that which cuts. Risk is associated with uncertainty and reflected by way of charge on the fundamental/basic. Risk may also be defined as the probability of incurring a loss or damage. In other words risk can be defined as the chance that the actual outcome from an activity will differ from the expected outcome. This means that, more variable the possible outcomes that can occur (i.e. broader the range of possible outcomes), the greater the risk. Risk management means a course of action planned to reduce the risk of an event occurring, and minimizing or containing the consequential effects should that event occur. It is one of those ideas, the sense that a logical, consistent and disciplined approach to the future uncertainties will allow us to live with them prudently and productively, avoiding unnecessary waste of resources. It goes beyond faith and luck, the twin pillars of managing the future before we began learning how to measure probability. As Peter Bernstein wrote, If everything is a matter of luck, risk management is a meaningless exercise. Invoking luck obscures truth, because it separates an event from its cause. Risk management does not aim at risk elimination, but enables the organization to bring their risks to manageable proportions while not severely affecting their income. This balancing act between the risk levels and profits needs to be well-planned. Apart from bringing the risks to manageable proportions, they should also ensure that one risk does not get transformed into any other undesirable risk. This transformation takes place due to the inter-linkage present among the various risks. The focal point in managing any risk will be to understand the nature of the transaction in a way to unbundle the risks it is exposed to. In todays volatile global economy, amidst swift and sudden shifts in currency trends, corporations worldwide increasingly regard foreign exchange exposure management as a critical component of their overall strategy to cut costs, manage risk and maximize corporate value. Foreign Exchange risk has been always an important subject of research. Traditionally, this research focused on the macroeconomic consequences of an exchange rate adjustment. More recently, the focal point of research has shifted to investigate the impact of exchange rate risk on corporate performance. The need for currency risk management started to arise after the breakdown of the Bretton Woods system and the end of the US dollar peg to gold in 1973. Exchange rate risk management is an integral part of every firm's decisions about foreign currency exposure. Currency risk hedging strategies entail eliminating or reducing this risk, and require understanding of both the ways that the exchange rate risk could affect the operations of economic agents and techniques to

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deal with the consequent risk implications. Selecting the appropriate hedging strategy is often a daunting task due to the complexities involved in measuring accurately current risk exposure and deciding on the appropriate degree of risk exposure that ought to be covered. As Indian businesses become more global in their approach, evolution of a broad based, active and liquid Forex (Foreign Exchange) derivatives markets is required to provide them with a spectrum of hedging products for effectively managing their foreign exchange exposures. Rise in volatility of exchange rates and interest rates have lead to a plethora of financial innovation, exemplified by the proliferation of derivative instruments and their increasing use by companies. While derivatives can be quite efficient hedging instruments for corporate risk management, they can be quite complex as well, with strong leverage effects. Consequently, the use of these instruments carries with it high risks, both for the unsophisticated user, as well as for managers tempted by an urge for gambling with their shareholders money. In contrast, when properly used for hedging, derivatives or various other financial transactions can reduce those risks of companies. Since the term hedging is widely misused in practice, a clear conceptual foundation is a key to management action consistent with the objective of firm value maximization. LITERATURE REVIEW Logue (1995) and Chowdhry and Howe (1999) argue that operating exposure cannot be effectively managed using financial hedges. Instead, they suggest that long-term strategy adjustments (i.e., operational hedges) are the most effective way of managing long-run operating exposure. According to Copeland and Joshi (1996), foreign exchange risk management programs may cause more harm than good. Their study of nearly two hundred large companies has yielded enough evidence to cast serious doubt about the economic benefits of foreign exchange hedging programs. Given scarce management time and the substantial amount of capital currently devoted to hedging, it is clear that many programs diminish value instead of creating it. Hedging theories assume a static world in which all factors apart from foreign exchange rates stay exactly the same. In addition, the relationships between these factors are shifting constantly. Hard enough to understand in hindsight, they are virtually impossible to predict in advance. Fok et al. (1997) have reported that although the primary purpose of hedging is to reduce earnings volatility, it may also increase firm value. Their study shows that hedging reduces the probability of financial distress, the agency costs of debt, and the costs of equity. In addition, they suggested that corporate ownership structure might affect the desirability of hedging. They also found that large firms had a stronger tendency to hedge, firms with a larger percentage of value derived from growth opportunities were more likely to hedge, and convertible debt served as a substitute for corporate hedging. The Foreign Exchange exposure of 171 Japanese multinationals was examined by He and Ng (1998). They documented that 25 percent of the firms experienced significant Foreign Exchange exposure. The extent to which a firm was exposed to Foreign Exchange risk was linked to the firms export ratio. He and Ng also examined the relationship between Foreign Exchange Exposure and variables that were assumed to reflect derivatives usage. The results showed that firms that were predicted to hedge had lower Foreign Exchange exposure, on average, than comparable sample firms.

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Ammon (1998) discussed two competing approaches to corporate hedging: equity value maximizing strategies and strategies determined by managerial risk aversion. The first category suggested that the managers acted in the best interest of shareholders. The second category considered that managers maximized their personal utility rather than the market value of equity. He concluded that the total benefits of hedging were not the sum total across the various motives. Therefore, a manager has to concentrate on a primary motive to implement an effective risk management program. Bodnar and Gebhardt (1998) carried out a comparative study of the responses to the survey of derivative usage between the US and German nonfinancial firms. Their study shows that German firms are more likely to use derivatives than US firms. Apart from this higher overall usage, the general pattern of usage across industry and size groupings is comparable across the two countries. In both countries, foreign currency derivative usage is most common, followed closely by interest rate derivatives, with commodity derivatives a distant third. In contrast to the similarities, firms in the two countries differ notably on issues such as the primary goal of hedging, their choice of instruments, and the influence of their market view when taking derivative positions. These differences appear to be driven by the greater importance of financial accounting statements in Germany than the US and stricter German corporate policies of control over derivative activities within the firm. Nydahl (1999) investigated 47 Swedish firms Foreign Exchange exposures. The evidence showed that exposure increased with the fraction of sales classified as foreign. Further, using survey evidence on firms hedging of foreign assets, Nydahl examined the association between translation exposure hedging and Foreign Exchange exposure. The results indicate that translation hedging reduced the sample firms Foreign Exchange exposure. Marshall (2000) empirically shows, furthermore, that contrary to the general view found in the literature derivatives use doesnt always decrease the variability of the firms value and that the degree of usage of certain techniques is even associated with an increase in the variability of certain financial measures. Wong (2000) investigated the Foreign Exchange exposure of manufacturing firms in the U.S. to test for an association between Foreign Exchange exposure and derivative disclosures required. He documented weak associations between derivative disclosures and Foreign Exchange exposure and suggested that this can be due to inability in controlling for firms inherent exposures and shortcomings of the accounting disclosures. The survey study of Yadav and Jain (2000) based on 44 corporate firms in India has shown that the Indian companies involved in international operations are conscious of the unique risks that arise as a result of doing business abroad. They report that companies are taking steps to manage political risk, exchange rate risk and interest rate risk. They observe that companies are covering a good part of their exchange rate risk and as many as 30 per cent of companies hedge their exposures in totality. Loderer and Pichler (2000) have observed that firms believe that their exposure is trivial and they fail to understand the importance of assessing their risk profiles. Joseph (2000) has studied the relationship between the use of hedging techniques and the characteristics of UK multinational enterprises. The study indicates that firms are not very receptive to the newer and more complex types of derivatives. Oosterhof (2001) has suggested that corporate risk management and hedging are important activities within financial as well as non-financial corporations. The study concluded that the

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major determinant of derivatives use is firm size. The mixed results indicate that corporate risk managers, willingly or unwillingly, do not behave in an optimal way. Hentschel and Kothari (2000) identify firms that use derivatives. They compare the risk exposure of derivative users to that of nonusers. They find economically small differences in equity return volatility between derivative users and nonusers. They also find that currency hedging has little effect on the currency exposure of firms' equity, even though derivatives use ranges from 0.6% to 64.2% of the firm's assets. Allayanis and Ofek (2001) performed an analysis on a sample of S&P 500 non-financial companies and calculated the companies exchange-rate exposure. They also tried isolating the impact of use of foreign currency derivatives (widely used for purpose of foreign exchange risk management) on firms foreign exchange exposures. The results of their study found a significant association between the absolute value of the exposures and the (absolute value) of the percentage use of foreign currency derivatives and prove that the use of derivatives in fact reduce exposure. Bengt Pramborg, in his study, Foreign Exchange Risk Management by Swedish and Korean Non Financial Firms: A Comparative Survey, 2002, makes a comparison of hedging practices of Swedish and Korean Firms. He suggests that Korean firms are more concerned about fluctuations in their cash flows whereas Swedish firms focus on accounting numbers. Derivatives usage is more popular for hedging among Swedish firms as compared to Korean firms. It may be a result of relative immaturity of Korean derivative markets. In both of the countries, majority of firms use a profit based approach to evaluate any risk management strategy. The study depicts that the decision to hedge foreign exchange exposure is driven by the level of exposure and size of a firm. Belk (2002) studied the organization of foreign exchange risk management among the multinational corporations in the UK, the US and Germany. He concluded that companies were generally risk-averse and the goals of currency risk management were not clearly formulated. Jesswein et al, (1995) in their study on use of derivatives by U.S. corporations, categorizes foreign exchange risk management products under three generations: Forward contracts belonging to the First Generation; Futures, Options, Futures- Options, Warranties and Swaps belonging to the Second Generation; and Range, Compound Options, Synthetic Products and Foreign Exchange Agreements belong to the Third Generation. The findings of the Study showed that the use of the third generation products was generally less than that of the second generation products, which was, in turn, less than the use of the first generation products. The use of these risk management products was generally not significantly related to the size of the company, but was significantly related to the company's degree of international involvement. Dufey and Giddy (2003) state several reasons why many organizations do not employ foreign exchange risk management techniques, such as lack of awareness about the importance of foreign exchange risk management, belief that the company does not need hedging, and the belief that company will be rewarded only when it takes risk and hence, no requirement for risk management. Bodnar et al. (2003) examined the influence of institutional differences on corporate risk management practices in the US and the Netherlands. Their study shows that institutional differences appear to have an important impact on risk management practices and derivatives use across US firms and Dutch firms.

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Abor (2005) suggested that foreign exchange risk can be managed by adjusting prices to reflect changes in import prices resulting from currency fluctuation, and also by buying and saving foreign currency in advance. The main problems that firms face are the frequent appreciation of foreign currencies against the local currency and the difficulty in retaining local customers because of the high prices of imported inputs, which tend to affect the prices of their final products sold locally. Yazid and Muda (2006) studied the usage pattern of foreign exchange management strategies in multinational corporations. They found that multinationals are involved in foreign exchange risk management primarily because they sought to minimize operational overall cash flows, which are affected by currency volatility. Also, the majority of multinationals centralizes their risk management activities and at the same time imposes greater control by frequent reporting on derivative activities. This level of caution could perhaps be because of huge financial losses related to derivative trading in the past. Sathya Swaroop Debasish in his 2008 paper Foreign Exchange Risk Management Practices A Study in Indian Scenario conducted an industry wide cross-sectional research on the techniques used by non-banking Indian based firms for foreign exchange risk management. The sampling of the study involved 501 non-banking Indian companies. The study identifies that the prime reason for hedging is the volatility and reduction in cash flows. The paper identifies and discusses the various foreign exchange risk management techniques in detail. The study finds out that forward contracts are the most commonly used techniques by Indian firms and it is then followed by swaps and cross-currency options. He has also mentioned that the currency risk management in India is growing at very slow pace and there should be urgency shown in using better-suited hedging instruments appropriate for the firms while considering the impact of the foreign exchange. Sivakumar and Sarkar (2008) in their paper Corporate Hedging for Foreign Exchange Risk in India evaluate the various alternatives available for Indian companies to hedge the foreign exchange risks. The paper studies various companies from various sectors and concludes that currency forwards and currency options are the most highly preferred hedging techniques used by Indian companies for short term hedging while swaps are preferred for long term hedging. They also discuss the various factors that influence the decision of the companies to hedge. Their research concluded that software companies in India have short term planning horizons when compared with high capital-intensive organizations. In general Indian firms choose short-term measures for hedging. The paper concluded that there is a need for rupee futures. Dash et al (2008), compared the performance of different FOREX risk management strategies for short-term foreign exchange cash flows. Their results indicated that, for outflows, the currency options strategy yielded the highest mean returns in all periods, irrespective of the movement in the exchange rate; while for inflows, the forwards strategy yielded the highest mean returns whenever there was a decreasing trend in the exchange rate, and the cross-currency strategy yielded the highest mean returns whenever there was a cyclic fluctuation in the exchange rate, however, when there was an increasing trend in the exchange rate, there was no single strategy yielding the highest mean returns. Objectives of the study To explain different approaches taken by non-banking companies in India towards foreign exchange risk management.

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To study the attitude of Indian Corporate towards risk arising out of foreign exchange exposure. To Study the use of foreign exchange derivatives and its benefits to non-banking companies in India To understand the level of awareness of derivatives and their uses, among the Corporate. To analyze how firms foreign exchange exposure is affected by different types of hedges. To examine the foreign exchange risk management practices among the listed companies To evaluate the various alternatives available to the Indian corporate for managing their foreign exchange risk METHODOLOGY An exploratory survey, by way of extensive literature review of books, journals , research and working papers and other published data related to the focus area of the study, as also concerned websites, were carried out to gather background information and past research literature. A survey was conducted among the listed non-financial companies, with the help of a self administered questionnaire. The target sample for this study is made up of about Indian companies that used foreign exchange derivatives. These companies were selected from the ET-500/FE-500 list. In order to be included in the sample, the company should have disclosed information about its use of currency derivatives in its annual report. In addition to the survey, additional interviews were conducted with a number of senior executives to get their views and comments. These interviews enabled me to probe many of the key issues and further explore lessons and perspectives of some of the leading companies. Data has been collected from annual reports and notes to the financial statements, as well. A thorough analysis of the annual reports enabled me to collect data on foreign operations and hedging practices of the sample non-financial companies. Information on notional as well as fair values of currency hedging positions was also sourced from the notes to the annual accounts. The questionnaires were sent to managers at companies that meet the following three criteria: (1) The company must be listed at the BSE/NSE (2) The company is a non-financial company, and (3) The companys headquarter is located in India. Financial companies were excluded because the focus of the study is on end-users rather than producers of financial services. Foreign companies were also excluded (companies with headquarters located outside India)

Analysis of Data A total of 90 organizations were approached for participating in the survey. A simple self administered questionnaire containing 20 questions to the potential respondents. Response was very slow and after too many follow-ups, a total of 26 responses could be obtained, resulting in response rate of 29%. To ensure that the final sample size represented an unbiased sample, the industry composition of and the company size of the intended sample were compared with the relative composition of the

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final respondents and the same was found to be fairly representative without any bias towards any particular industry or size.

IT / IT Services Pharmaceuticals FMCG Consumer durables Infrastructure Telecommunication Others

Total responses received 7 4 4 2 3 2 4 26

Intended Sample Size 23 13 12 8 12 6 16 90

Responses and analysis of data Q-1) What is the primary source of foreign exchange exposure for your company : Q-2) If both exports and imports are a source of foreign exchange exposure for your company, which one is a more dominant source

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Q-3) While entering into foreign contracts do you consider the foreign exchange risk involved:

Q-4) If you consider the foreign exchange risk involved while entering into foreign contracts, do you hedge your exposure :

Q-5) How do you hedge your foreign currency exposure

Q-6) Which derivative instrument do you use to hedge your foreign currency exposure

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Q-7) If you consider the foreign exchange risk involved while entering into foreign contracts, but chose not to hedge your exposure, the reason :

Q-8) In your view, do you think Currency volatility would increase in the days to come

Q-9) In your view, do you think Rupee will depreciate or appreciate further against the USD

Q-10) What are the objectives of your Risk Management strategies

Q-11) The primary focus of the risk management process in your company is on :

Q-12) What are your main concerns while managing your foreign exchange exposure

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Q-13) What do you treat your treasury function as :

Q-14) What best describes your companys attitude towards its foreign exchange exposure

Q-15) How satisfied are you with the present exchange risk management process of your company :

Q-16) In your view is the RBI doing enough to contain the continuous fall of Rupee?

Q-17) What is your long term outlook of the Rupee?

Q-18) Does your company have a designated Chief Risk Officer Other than your CFO :

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Q-19) Does your company have a documented foreign exchange risk management policy :

CONCLUSION AND RECOMMENDATION The study throws up some very interesting insights and break quite a myth related to the level of awareness that corporate in India have on the complex subject of exchange rate derivatives. Both imports and exports are a source of exchange exposure for Indian companies. The fact that the respondents did not include any oil refiner, and had a healthy representation of companies who generate a substantial part of their revenue through exports may have lead to a slightly tilted outcome in favour of exporters. Most of the respondents consider the exchange risk involved while entering into a foreign contract. An overwhelming majority of those who consider such risk involved, hedge their exposure. Majority of the respondents used external techniques to hedge their foreign exchange exposure. Since the study excluded the non-indian MNCs, it is possible that for the corporate covered in the study, the ability to employ internal techniques to hedge their exchange exposure is limited. Forward contracts appear to be most commonly used techniques by Indian firms although the majority of the respondents use a combination of forward contracts, swaps and option to hedge. For respondents who stated that they do not hedge their exchange exposure, the majority chose not to do so as they felt that their exposures are not large enough as well as either they do not understand the derivatives too well or find them too pricey/risky. On their view on the continuing volatility in the forex markets, majority were uncertain on the future of the current volatility. However most of them believed that Rupee will depreciate even further. Minimizing the volatility in their cash flows was the single largest reason cited by the respondents to be the key objective of their risk management strategy. This

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was substantiated by an identical proportion of respondents treating the Transaction risk as the primary focus of their risk management strategy. Difficulty in quantifying the exposure was the single largest concern cited by the respondents. An overwhelming majority of respondents consider their treasury function as a cost centre Most interestingly the largest proportion of respondents see little benefit in hedging. This is particularly surprising given that for majority of the respondents had a well evolved hedging program. Majority of the respondents were satisfied with the effectiveness of their present exchange risk management program. On RBIs level of intervention to the ongoing currency turmoil, majority believed that RBI is doing enough or at least doing something, though it could do more. An overwhelming proportion was quite positive on the long term outlook for rupee.

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