Financial Management –Forex Risk Management

FINANCIAL MANAGEMENT

A Report Submitted for External Assessment on

Project Topic: Forex Risk Management.

Under The Guidance Of

Mr. DC Jain, DEE CEE Pearls

NEW DELHI

STUDENT NAME: ISHMEET SINGH KOHLI

BATCH: UGP FW 2007-2010/ PGP FW 2008-2010

Ph.: 9999971855

EMAIL: ishmeet_800855@yahoo.co.in

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ACKNOWLEDGEMENT:

At the onset we would like to express our enormous gratitude towards MD of DEE CEE Pearls,

Mr. D.C Jain’ for his continuous encouragement and guidance throughout our research work.

His approach helped us converting ideas into definable results. We thank him for his timely

guidance.

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INDEX

S.No. Contents Page No.

1. Abstract 4

2. Introduction 5

3. India in Global Forex Market 12

4. Determinants 13

5. Forex Risk Management Process & Necessity 16

6. Forex Risk Management Framework 18

7. Hedging Instruments 21

8. Factors affecting the Hedging 25

9. Recommendations 28

10. Basic Problems 29

11. Conclusion 31

13. Bibliography 32

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Abstract
Indian economy in the post-liberalization era has witnessed increasing awareness of the need for

Introduction of various risk management products to enable hedging against market risk in a cost

Effective way. This industry-wide, cross-sectional study concentrates on recent foreign exchange

risk management practices and derivatives product usage by large non-banking Indian-based

firms. The study is exploratory in nature and aims at an understanding the risk appetite and

FERM (Foreign Exchange Risk Management) practices of Indian corporate enterprises. This

study focuses on the activity of end-users of financial derivatives and is confined to 501 non-

banking corporate enterprises. A combination of simple random and judgment sampling was

used for selecting the corporate enterprises and the major statistical tools used were Correlation

and Factor analysis. The study finds wide usage of derivative products for risk management and

the prime reason of hedging is reduction in volatility of cash flows. VAR (Value-at-Risk)

technique was found to be the preferred method of risk evaluation by maximum number of

Indian corporate. Further, in terms of the external techniques for risk hedging, the preference is

mostly in favor of forward contracts, followed by swaps and cross-currency options This article

throws light on various concerns of Indian firms regarding derivative usage and reasons for non-

usage, apart from techniques of risk hedging, risk evaluation methods adopted, risk management

policy and types of derivatives used. Foreign exchange exposure refers to the sensitivity of a

firm’s cash flows to changes in exchange rates. This study develops a model of foreign exchange

exposure dependent on only three variables, the percentage of the firm’s revenues and expenses

denominated in foreign currency and its profit rate.

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Introduction

INDIAN FOREIGN EXCHANGE MARKET: A HISTORICAL PERSPECTIVE

Early Stages: 1947-1977

The evolution of India’s foreign exchange market may be viewed in line with the shifts in India’s

Exchange rate policies over the last few decades from a par value system to a basket-peg and

further to a managed float exchange rate system. During the period from 1947 to 1971, India

followed the par value system of exchange rate. Initially the rupee’s external par value was fixed

at 4.15 grains of fine gold. The Reserve Bank maintained the par value of the rupee within the

permitted margin of ±1 per cent using pound sterling as the intervention currency. Since the

sterling-dollar exchange rate was kept stable by the US monetary authority, the exchange rates of

rupee in terms of gold as well as the dollar and other currencies were indirectly kept stable. The

Devaluation of rupee in September 1949 and June 1966 in terms of gold resulted in the reduction

of the par value of rupee in terms of gold to 2.88 and 1.83 grains of fine gold, respectively. The

exchange rate of the rupee remained unchanged between 1966 and 1971. With the breakdown of

the Bretton Woods System in 1971 and the floatation of major currencies, the conduct of

exchange rate policy posed a serious challenge to all central banks worldwide as currency

fluctuations opened up tremendous opportunities for market players to trade in currencies

in a borderless market. In December 1971, the rupee was linked with pound sterling. Since

sterling was fixed in terms of US dollar under the Smithsonian Agreement of 1971, the rupee

also remained stable against dollar. In order to overcome the weaknesses associated with a single

currency peg and to ensure stability of the exchange rate, the rupee, with effect from September

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1975, was pegged to a basket of currencies. The currency selection and weights assigned were

left to the discretion of the Reserve Bank. The currencies included in the basket as well

as their relative weights were kept confidential in order to discourage speculation. It was around

this time that banks in India became interested in trading in foreign exchange.

Formative Period: 1978-1992

The impetus to trading in the foreign exchange market in India came in 1978 when banks in

India were allowed by the Reserve Bank to undertake intra-day trading in foreign exchange and

were required to comply with the stipulation of maintaining ‘square’ or ‘near square’ position

only at the close of business hours each day. The extent of position which could be left covered

overnight (the open position) as well as the limits up to which dealers could trade during the day

was to be decided by the management of banks. The exchange rate of the

rupee during this period was officially determined by the Reserve Bank in terms of a weighted

basket of currencies of India’s major trading partners and the exchange rate regime was

characterized by daily announcement by the Reserve Bank of its buying and selling rates to the

Authorized Dealers (ADs) for undertaking merchant transactions. The spread between the buying

and the selling rates was 0.5 per cent and the market began to trade actively within this range.

ADs were also permitted to trade in cross currencies (one convertible foreign currency versus

another). However, no ‘position’ in this regard could originate in overseas markets.

As opportunities to make profits began to emerge, major banks in India started quoting two ways

prices against the rupee as well as in cross currencies and, gradually, trading volumes began to

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increase. This led to the adoption of widely different practices (some of them being irregular)

and the need was felt for a comprehensive set of guidelines for operation of banks engaged in

foreign exchange business. Accordingly, the ‘Guidelines for Internal Control over Foreign

Exchange Business’ were framed for adoption by the banks in 1981. The foreign exchange

market in India till the early 1990s, however, remained highly regulated with restrictions on

external transactions, barriers to entry, low liquidity and high transaction costs. The exchange

rate during this period was managed mainly for facilitating India’s imports. The strict control on

foreign exchange transactions through the Foreign Exchange Regulations Act (FERA) had

resulted in one of the largest and most efficient parallel markets for foreign exchange in the

world, i.e., the hawala (unofficial) market.

By the late 1980s and the early 1990s, it was recognized that both macroeconomic policy and

structural factors had contributed to balance of payments difficulties. Devaluations by India’s

competitors had aggravated the situation. Although exports had recorded a higher growth during

the second half of the 1980s (from about 4.3 per cent of GDP in 1987-88 to about 5.8 per cent of

GDP in 1990-91), trade imbalances persisted at around 3 per cent of GDP. This combined with a

precipitous fall in invisible receipts in the form of private remittances, travel and tourism

earnings in the year 1990-91 led to further widening of current account deficit. The weaknesses

in the external sector were accentuated by the Gulf crisis of 1990-91. As a result, the current

account deficit widened to 3.2 per cent of GDP in 1990-91 and the capital flows also dried up

necessitating the adoption of exceptional corrective steps. It was against this backdrop that India

embarked on stabilization and structural reforms in the early 1990s.

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Post-Reform Period: 1992 onwards

This phase was marked by wide ranging reform measures aimed at widening and deepening the

foreign exchange market and liberalization of exchange control regimes. A credible

macroeconomic, structural and stabilization program encompassing trade, industry, foreign

investment, exchange rate, public finance and the financial sector was put in place creating an

environment conducive for the expansion of trade and investment. It was recognized that trade

policies, exchange rate policies and industrial policies should form part of an integrated policy

framework to improve the overall productivity, competitiveness and efficiency of the economic

system, in general, and the external sector, in particular. As a stabilzation measure, a two step

downward exchange rate adjustment by 9 per cent and 11 per cent between July 1 and 3, 1991

was resorted to counter the massive drawdown in the foreign exchange reserves, to instill

confidence among investors and to improve domestic competitiveness. A two-step adjustment of

exchange rate in July 1991 effectively brought to close the regime of a pegged exchange rate.

After the Gulf crisis in 1990-91, the broad framework for reforms in the external sector was laid

out in the Report of the High Level Committee on Balance of Payments (Chairman: Dr. C.

Rangarajan). Following the recommendations of the Committee to move towards the market-

determined exchange rate, the Liberalized Exchange Rate Management System (LERMS) was

put in place in March 1992 initially involving a dual exchange rate system. Under the LERMS,

all foreign exchange receipts on current account transactions (exports, remittances, etc.) were

required to be surrendered to the Authorized Dealers (ADs) in full.

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The rate of exchange for conversion of 60 per cent of the proceeds of these transactions was the

market rate quoted by the ADs, while the remaining 40 per cent of the proceeds were converted

at the Reserve Bank’s official rate. The ADs, in turn, were required to surrender these 40 per cent

of their purchase of foreign currencies to the Reserve Bank. They were free to retain the balance

60 per cent of foreign exchange for selling in the free market for permissible transactions. The

LERMS was essentially a transitional mechanism and a downward adjustment in the official

exchange rate took place in early December 1992 and ultimate convergence of the dual rates was

made effective from March 1, 1993, leading to the introduction of a market-determined exchange

rate regime. The dual exchange rate system was replaced by a unified exchange rate system in

March 1993, whereby all foreign exchange receipts could be converted at market determined

exchange rates. On unification of the exchange rates, the nominal exchange rate of the rupee

against both the US dollar as also against a basket of currencies got adjusted lower, which almost

nullified the impact of the previous inflation differential. The restrictions on a number of other

current account transactions were relaxed. The unification of the exchange rate of the Indian

rupee was an important step towards current account convertibility, which was finally achieved

in August 1994, when India accepted obligations under Article VIII of the Articles of Agreement

of the IMF. With the rupee becoming fully convertible on all current account transactions, the

risk-bearing capacity of banks increased and foreign exchange trading volumes started rising.

This was supplemented by wide-ranging reforms undertaken by the Reserve Bank in conjunction

with the Government to remove market distortions and deepen the foreign exchange market. The

process has been marked by ‘gradualism’ with measures being undertaken after extensive

consultations with experts and market participants. The reform phase began with the Sodhani

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Committee (1994) which in its report submitted in 1995 made several recommendations to relax

the regulations with a view to vitalizing the foreign exchange market.

A Forex market is a market that facilitates exchange of currencies. The world is emerging as a

global economy because of flow of goods, services and capital. For each transaction of goods

and services there is a corresponding currency transaction, which forms a part of an international

network of payments. The increase in world trade and the lowering of capital controls have led to

tremendous growth in the foreign exchange market over the years. It offers unparalleled personal

and financial freedom to make money as well as lose it in no time. It is described as the „fairest

market on earth‟ for it is so large that no one player, not even large government can completely

control its directions. The Indian Forex market is in its evolving stage, the market is described as

thin with few players and low volumes unlike the global scenario. The main reason for low

volumes is the non-convertibility of rupee on capital account. This research report will give

insight about the evolution of the Indian Forex market and the importance of Forex market in a

developing economy like India.

The foreign exchange market has gained a lot of importance in recent years and has become an

essential part of every economy, but there are very few developed foreign exchange markets

today. London is the Forex capital of the world today and others are mostly centered on

organized markets like New York, Tokyo, Zurich, Honk Kong, Singapore etc. India being one of

the fastest growing economies of the world and its ambition to become a developed economy by

2020, it needs a developed Forex market to back its economy.

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The Forex market is special in a number of ways. We cannot designate any physical location

where Forex traders get together to exchange currencies. Rather, traders are located in offices of

major commercial banks around the world and communicate using computer terminals,

telephones and other information channels. The international scope of the Forex market implies

the absence of any central regulatory authority. Instead the Forex market provides an example of

private regulation, where market participants agree on a common set of rules governing

transactions and their settlement. Hence, the Forex market is certainly not a chaotic realm of

lawlessness. In fact ethical and professional standards are essential in an economic environment

in which a single verbal agreement on a telephone can commit millions of dollars or euros. The

Forex market differs from other financial markets in a number of respects. First, it is by far the

world’s largest financial market in terms of transaction volume. The daily transaction volume in

all currencies is estimated to amount to $3.98 trillion a day. This is gigantic even in comparison

to a very active equity market like the New York Stock Exchange, which reaches an average

daily volume of approximately US$ 296 billion a day. Secondly, the Forex market is also a

market with extraordinarily low transaction costs. A common measure to express transaction

costs is to calculate quoted spreads as the price difference between a buy (ask) and a sell (bid)

order for a currency rate relative to the mid-price

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India in Global Forex market

As per the BIS Triennial Survey on the global foreign exchange and derivatives market activity

(2007), the foreign exchange market in India has grown into the 16th largest market in the world

in terms of total daily turnover which was US$34 billion in 2007. The OTC derivatives segment

of the foreign exchange market has also increased significantly to register a daily average

turnover of USD 24 billion, which is 17th largest among all countries. The daily turnover has

increased to US$48 billion in 2007-08. There is no ready template available internationally that

India could draw upon since most of the countries that have active currency futures markets are

those which are relatively more convertible on the capital. The introduction of currency futures

last year has provided further depth and breadth to the market and fulfills the intended objective

as an effective risk-management instrument. This is leading to an urge in all the market

participants to leverage this significant milestone for skill development within as well as at a

broader industry level.

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Determinants
In a floating exchange rate mechanism, foreign exchange rate is determined much in the same

way as the price of any commodity in a free market economy. Appreciation or depreciation of

the domestic currency thus depends on the supply of foreign exchange reserves, liquidity

conditions in the economy as determined by money supply, central bank’s policy intentions and

differences in the interest yield on dated securities of the concerned economies. The determinants

of exchange rate are discussed as follows:

The Bank Rate:

Changes in the bank rate indicate the monetary policy intentions of the RBI. If such a change is

unanticipated, economic agents alter their expectations regarding the future monetary policy.

Thus, an increase in the bank rate indicates a tight monetary policy, and is counter-reacted with

an expectation that the bank rate will decline in future. This results in a depreciation of the

domestic currency. On the contrary, the increase in bank rate may also result in further tightening

of the monetary policy by the RBI, which is necessary for lowering the inflation in the domestic

economy as against the foreign economy. A future appreciation of domestic currency is

anticipated here, causing an appreciation of the current exchange rate. To incorporate this effect,

data on bank rate are included. Simultaneously, the impact of the differences between the cost of

long-term and short-term liquidity are also included by introducing the difference between inter-

bank call money rate and the bank rate. Five-period lag values point out any lag effect of the

same on the exchange rate.

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Interest Yield Differentials: The relation between short-term and long-term interest yield

differentials and exchange rate is complex. An increase in the interest differential between

domestic securities and foreign securities indicates a rise in the gain from capital inflows into the

economy. This is expected to result in a depreciation of the domestic currency. The nominal

interest differential reflects both the real interest differential and the inflation differential. The

inverse relation between the exchange rate and nominal interest differential is due to the inflation

differential. Thus, if inflation in India exceeds the inflation in the US, the nominal interest

differential is positive, making a positive gain on capital in India possible.

Liquidity:

The growth rates of broad money and foreign exchange reserves indicate increased liquidity in

the economy. Such an increase in the liquidity is expected to cause depreciation in the exchange

rate. An anticipation of inflation due to increased liquidity and increase in the aggregate demand

is two major causes behind such depreciation. However, an increase in the foreign exchange

reserves also implies an increase in the supply of foreign currency, which often results in

appreciation of the domestic currency.

External Shocks:

The concept of external shock affecting the exchange market can be explained by two real life

examples. The first such shock relates to the month of December 1997. In spite of strong

economic fundamentals, market sentiment weakened sharply during September 1997 to January

1998. Profit taking by FIIs on the stock exchanges added to the pressure on the rupee in

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November. The market was driven by downside expectations created largely in the backwash of

the currency turmoil in South- East Asia and political developments within the country. Excess

demand conditions reflected in the intensified spot merchant transactions too. The volatility in

the exchange market and the swing in the market sentiments were reflected in the significant

spurt in inter-bank and merchant turnover by November and December 1997 in relation to April-

June 1997 levels. Over the quarter October-December 1997, there was a nominal depreciation of

the spot exchange rate by about 7.6 per cent, and the value of rupee eroded by more than 5.3 per

cent in the month of December alone. Another major shock was felt in April 2007, when the

rupee appreciated by almost 4.3 per cent. This was mainly due to strong domestic economic

growth vis-à-vis moderating of the US economy during the previous two years, robust growth in

the euro area and narrowing interest differentials. Large capital inflows due to increasing

investor interest, dampening crude oil prices in the world market and depreciation in dollar

against other currencies further added to appreciation of the rupee.

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Foreign Exchange Risk Management: Process & Necessity

Firms dealing in multiple currencies face a risk (an unanticipated gain/loss) on account of

sudden/unanticipated changes in exchange rates, quantified in terms of exposures. Exposure is

defined as a contracted, projected or contingent cash flow whose magnitude is not certain at the

moment and depends on the value of the foreign exchange rates. The process of identifying risks

faced by the firm and implementing the process of protection from these risks by financial or

operational hedging is defined as foreign exchange risk management. This paper limits its scope

to hedging only the foreign exchange risks faced by firms.

Kinds of Foreign Exchange Exposure

Risk management techniques vary with the type of exposure (accounting or economic) and term

of exposure. Accounting exposure, also called translation exposure, results from the need to

restate foreign subsidiaries’ financial statements into the parent’s reporting currency and is the

sensitivity of net income to the variation in the exchange rate between a foreign subsidiary and

its parent. Economic exposure is the extent to which a firm's market value, in any particular

currency is sensitive to unexpected changes in foreign currency. Currency fluctuations affect the

value of the firm’s operating cash flows, income statement, and competitive position, hence

market share and stock price. Currency fluctuations also affect a firm's balance sheet by

changing the value of the firm's assets and liabilities, accounts payable, accounts receivables,

inventory, loans in foreign currency, investments (CDs) in foreign banks; this type of economic

exposure is called balance sheet exposure. Transaction Exposure is a form of short term

economic exposure due to fixed price contracting in an atmosphere of exchange-rate volatility.

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The most common definition of the measure of exchange-rate exposure is the sensitivity of the

value of the firm, proxied by the firm’s stock return, to an unanticipated change in an exchange

rate. This is calculated by using the partial derivative function where the dependent variable is

the firm’s value and the independent variable is the exchange rate (Adler and Dumas, 1984).

Necessity of managing foreign exchange risk

A key assumption in the concept of foreign exchange risk is that exchange rate changes are not

predictable and that this is determined by how efficient the markets for foreign exchange are.

Research in the area of efficiency of foreign exchange markets has thus far been able to establish

only a weak form of the efficient market hypothesis conclusively which implies that successive

changes in exchange rates cannot be predicted by analyzing the historical sequence of exchange

rates.(Soenen, 1979). However, when the efficient markets theory is applied to the foreign

exchange market under floating exchange rates there is some evidence to suggest that the

present prices properly reflect all available information. (Giddy and Dufey, 1992).

This implies that exchange rates react to new information in an immediate and unbiased fashion,

so that no one party can make a profit by this information and in any case, information on

direction of the rates arrives randomly so exchange rates also fluctuate randomly. It implies that

foreign exchange risk management cannot be done away with by employing resources to predict

exchange rate changes.

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Foreign Exchange Risk Management Framework

Once a firm recognizes its exposure, it then has to deploy resources in managing it. A heuristic

for firms to manage this risk effectively is presented below which can be modified to suit firm-

specific needs i.e. some or all the following tools could be used.

 Forecasts: After determining its exposure, the first step for a firm is to develop a forecast

on the market trends and what the main direction/trend is going to be on the foreign

exchange rates. The period for forecasts is typically 6 months. It is important to base the

forecasts on valid assumptions. Along with identifying trends, a probability should be

estimated for the forecast coming true as well as how much the change would be.

 Risk Estimation: Based on the forecast, a measure of the Value at Risk (the actual profit

or loss for a move in rates according to the forecast) and the probability of this risk

should be ascertained. The risk that a transaction would fail due to market-specific

problems should be taken into account. Finally, the Systems Risk that can arise due to

inadequacies such as reporting gaps and implementation gaps in the firms’ exposure

management system should be estimated.

 Benchmarking: Given the exposures and the risk estimates, the firm has to set its limits

for handling foreign exchange exposure. The firm also has to decide whether to manage

its exposures on a cost center or profit center basis. A cost center approach is a defensive

one and the main aim is ensure that cash flows of a firm are not adversely affected

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beyond a point. A profit center approach on the other hand is a more aggressive approach

where the firm decides to generate a net profit on its exposure over time.

 Hedging: Based on the limits a firm set for itself to manage exposure, the firms then

decides an appropriate hedging strategy. There are various financial instruments available

for the firm to choose from: futures, forwards, options and swaps and issue of foreign

debt. Hedging strategies and instruments are explored in a section.

 Stop Loss: The firms risk management decisions are based on forecasts which are but

estimates of reasonably unpredictable trends. It is imperative to have stop loss

arrangements in order to rescue the firm if the forecasts turn out wrong. For this, there

should be certain monitoring systems in place to detect critical levels in the foreign

exchange rates for appropriate measure to be taken.

 Reporting and Review: Risk management policies are typically subjected to review

based on periodic reporting. The reports mainly include profit/ loss status on open

contracts after marking to market, the actual exchange/ interest rate achieved on each

exposure and profitability vis-à-vis the benchmark and the expected changes in overall

exposure due to forecasted exchange/ interest rate movements. The review analyses

whether the benchmarks set are valid and effective in controlling the exposures, what the

market trends are and finally whether the overall strategy is working or needs change.

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Hedging Strategies/ Instruments

A derivative is a financial contract whose value is derived from the value of some other financial

asset, such as a stock price, a commodity price, an exchange rate, an interest rate, or even an

index of prices. The main role of derivatives is that they reallocate risk among financial market

participants, help to make financial markets more complete. This section outlines the hedging

strategies using derivatives with foreign exchange being the only risk assumed.

 Forwards: A forward is a made-to-measure agreement between two parties to buy/sell a

specified amount of a currency at a specified rate on a particular date in the future. The

depreciation of the receivable currency is hedged against by selling a currency forward. If

the risk is that of a currency appreciation (if the firm has to buy that currency in future

say for import), it can hedge by buying the currency forward. Eg if RIL wants to buy

crude oil in US dollars six months hence, it can enter into a forward contract to pay INR

and buy USD and lock in a fixed exchange rate for INR-USD to be paid after 6 months

regardless of the actual INR-Dollar rate at the time. In this example the downside is an

appreciation of Dollar which is protected by a fixed forward contract. The main

advantage of a forward is that it can be tailored to the specific needs of the firm and an

exact hedge can be obtained. On the downside, these contracts are not marketable, they

can’t be sold to another party when they are no longer required and are binding.

 Futures: A futures contract is similar to the forward contract but is more liquid because

it is traded in an organized exchange i.e. the futures market. Depreciation of a currency

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can be hedged by selling futures and appreciation can be hedged by buying futures.

Advantages of futures are that there is a central market for futures which eliminates the

problem of double coincidence. Futures require a small initial outlay (a proportion of the

value of the future) with which significant amounts of money can be gained or lost with

the actual forwards price fluctuations. This provides a sort of leverage. The previous

example for a forward contract for RIL applies here also just that RIL will have to go to a

USD futures exchange to purchase standardized dollar futures equal to the amount to be

hedged as the risk is that of appreciation of the dollar. As mentioned earlier, the tailor

ability of the futures contract is limited i.e. only standard denominations of money can be

bought instead of the exact amounts that are bought in forward contracts.

 Options: A currency Option is a contract giving the right, not the obligation, to buy or

sell a specific quantity of one foreign currency in exchange for another at a fixed price;

called the Exercise Price or Strike Price. The fixed nature of the exercise price reduces

the uncertainty of exchange rate changes and limits the losses of open currency positions.

Options are particularly suited as a hedging tool for contingent cash flows, as is the case

in bidding processes. Call Options are used if the risk is an upward trend in price (of the

currency), while Put Options are used if the risk is a downward trend. Again taking the

example of RIL which needs to purchase crude oil in USD in 6 months, if RIL buys a

Call option (as the risk is an upward trend in dollar rate), i.e. the right to buy a specified

amount of dollars at a fixed rate on a specified date, there are two scenarios. If the

exchange rate movement is favorable i.e. the dollar depreciates, then RIL can buy them at

the spot rate as they have become cheaper. In the other case, if the dollar appreciates

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compared to today’s spot rate, RIL can exercise the option to purchase it at the agreed

strike price. In either case RIL benefits by paying the lower price to purchase the dollar

 Swaps: A swap is a foreign currency contract whereby the buyer and seller exchange

equal initial principal amounts of two different currencies at the spot rate. The buyer and

seller exchange fixed or floating rate interest payments in their respective swapped

currencies over the term of the contract. At maturity, the principal amount is effectively

re-swapped at a predetermined exchange rate so that the parties end up with their original

currencies. The advantages of swaps are that firms with limited appetite for exchange rate

risk may move to a partially or completely hedged position through the mechanism of

foreign currency swaps, while leaving the underlying borrowing intact. Apart from

covering the exchange rate risk, swaps also allow firms to hedge the floating interest rate

risk. Consider an export oriented company that has entered into a swap for a notional

principal of USD 1 MN at an exchange rate of 42/dollar. The company pays US 6months

LIBOR to the bank and receives 11.00% p.a. every 6 months on 1st January & 1st July,

till 5 years. Such a company would have earnings in Dollars and can use the same to pay

interest for this kind of borrowing (in dollars rather than in Rupee) thus hedging its

exposures.

 Foreign Debt: Foreign debt can be used to hedge foreign exchange exposure by taking

advantage of the International Fischer Effect relationship. This is demonstrated with the

example of an exporter who has to receive a fixed amount of dollars in a few months

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from present. The exporter stands to lose if the domestic currency appreciates against that

currency in the meanwhile so, to hedge this; he could take a loan in the foreign currency

or the same time period and convert the same into domestic currency at the current

exchange rate. The theory assures that the gain realized by investing the proceeds from

the loan would match the interest rate payment (in the foreign currency) for the loan.

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Factors affecting the decision to hedge foreign currency risk

Research in the area of determinants of hedging separates the decision of a firm to hedge from

that of how much to hedge. There is conclusive evidence to suggest that firms with larger size,

R&D expenditure and exposure to exchange rates through foreign sales and foreign trade are

more likely to use derivatives. (Allayanis and Ofek, 2001) First, the following section describes

the factors that affect the decision to hedge and then the factors affecting the degree of hedging

are considered.

 Firm size: Firm size acts as a proxy for the cost of hedging or economies of scale. Risk

management involves fixed costs of setting up of computer systems and training/hiring of

personnel in foreign exchange management. Moreover, large firms might be considered

as more creditworthy counterparties for forward or swap transactions, thus further

reducing their cost of hedging. The book value of assets is used as a measure of firm size.

 Leverage: According to the risk management literature, firms with high leverage have

greater incentive to engage in hedging because doing so reduces the probability, and thus

the expected cost of financial distress. Highly levered firms avoid foreign debt as a means

to hedge and use derivatives.

 Liquidity and profitability: Firms with highly liquid assets or high profitability have

less incentive to engage in hedging because they are exposed to a lower probability of

financial distress. Liquidity is measured by the quick ratio, i.e. quick assets divided by

current liabilities). Profitability is measured as EBIT divided by book assets.

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 Sales growth: Sales growth is a factor determining decision to hedge as opportunities are

more likely to be affected by the underinvestment problem. For these firms, hedging will

reduce the probability of having to rely on external financing, which is costly for

information asymmetry reasons, and thus enable them to enjoy uninterrupted high

growth. The measure of sales growth is obtained using the 3-year geometric average of

yearly sales growth rates.

Managing foreign exchange risk is a fundamental component in the safe and sound management

of all institutions that have exposures in foreign currencies. It involves prudently managing

foreign currency positions in order to control, within set parameters, the impact of changes in

exchange rates on the financial position of the institution. The frequency and direction of rate

changes, the extent of the foreign currency exposure and the ability of counterparts to honor their

obligations to the institution are significant factors in foreign exchange risk management.

Although the particulars of foreign exchange risk management will differ among institutions

depending upon the nature and complexity of their foreign exchange activities, a comprehensive

foreign exchange risk management program requires:

 Establishing and implementing sound and prudent foreign exchange risk

management policies; and

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 Developing and implementing appropriate and effective foreign exchange risk

management and control procedures.

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Recommendations on Foreign Exchange Markets in India

Mr. DC Jain recommended included exemption of domestic interbank borrowings from

SLR/CRR requirements to facilitate development of the term money market, cancellation and re-

booking of currency options, permission to offer lower cost option strategies such as the ‘range

forward’ and ‘ratio range forward’ and permitting ADs to offer any derivative products on a fully

covered basis which can be freely used for their own asset liability management.

As part of long-term measures, the Group suggested that the Reserve Bank should invite detailed

proposals from banks for offering rupee-based derivatives, should refocus exchange control

regulation and guidelines on risks rather than on products and frame a fresh set of guidelines for

foreign exchange and derivatives risk management.

As regards accounting and disclosure standards, the main recommendations included reviewing

of policy procedures and transactions on an on-going basis by a risk control team independent of

dealing and settlement functions, ensuring of uniform documentation and market practices by the

Foreign Exchange Dealers’ Association of India (FEDAI) or any other body and development of

accounting disclosure standards

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Basic Problems faced by exporters while hedging through

derivatives
Factor Analysis reveals that the main factor responsible for non-use of derivatives is confused

perceptions of derivatives use, with its components, concerns about the appropriateness of

derivatives in specific situations, risk of the products and general reluctance and fear. Then

comes the technical and administrative factor comprising difficulty in pricing and policy

constraints, followed by the cost effectiveness factor which questions the utility of derivatives,

given the high costs involved. As to the nature of the transactions that are considered for

hedging, the responses indicate that hedging is resorted to mostly in respect of transactions

involving contractual commitments, rather than foreign repatriations. There also seems

to be a preference to restrict the hedging horizon to less than a year. Even among the users of

derivatives, the concerns or anxieties about their use arise on several counts. Factor analysis of

these, reduced them to four factors:

(i) Confused perception, including lack of clarity about investor expectations, difficulties in

pricing and valuing, difficulties in evaluating the risk and lack of understanding as to how to

monitor and evaluate hedging outcome.

(ii) Policy and legal issues, covering assessment of credit risk, inadequate support from the

Board, tax and legal considerations and disclosure requirements.

(iii) Monetary considerations, concerned with transaction costs and liquidity problems.

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(iv) Lack of adequate knowledge about the use of derivatives.

65% of the exporters/importers were of the view that enough range of derivative instruments is

not available yet. A good majority felt the need for Rupee-Dollar Options, while others wished

that Exchange-Traded Futures were available. From the above, it can be seen that the Indian

corporate enterprises are somewhat halting in their approach to the use of derivatives.

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Conclusion
Derivative use for hedging is only to increase due to the increased global linkages and volatile

exchange rates. Firms need to look at instituting a sound risk management system and also need

to formulate their hedging strategy that suits their specific firm characteristics and exposures.

In India, regulation has been steadily eased and turnover and liquidity in the foreign currency

derivative markets has increased, although the use is mainly in shorter maturity contracts of one

year or less. Forward and option contracts are the more popular instruments. Regulators had

initially only allowed certain banks to deal in this market however now corporates can also write

option contracts. There are many variants of these derivatives which investment banks across the

world specialize in, and as the awareness and demand for these variants increases, RBI would

have to revise regulations.

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Bibliography
http://www.wikipedia.org/

http://www.investopedia.com/

http://www.worldforex.org/

http://www.rbi.org/

http://www.books.google.co.in

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