The objective of the project is to study the attitude of Indian corporates towards currency risk management and the problems faced by the companies dealing with their currency exposure which occur as a result of exports or imports or both. The study has also included the problems faced by the banks, the authorised dealers of foreign exchange in India, in managing their forex (foreign exchange) market operation as it has large implication on the corporate currency exposure.
Indian corporates have an attitude of staying away from the currency market. Companies consider hedging as unwanted cost centres. Periods of exchange rate stability bred complacency. Importers are confident that the Central banks shall intervene to halt any rupee decline where a exporters are of the view that rupee has always been over rated and that there is no way that it shall appreciate from the present value. These reason keep them away from hedging their exposures.
Companies which are involved in hedging, go the conservative and orthodox way to hedge their exposure. Not a single company surveyed, take financial derivatives other than forward contracts as tool for hedging their exposure. This is mainly because of lack of awareness and experience. Many of the companies feel that the importance of currency risk management will increase, in coming years but very few of them are making themselves ready to face the situation.
Banks that act as facilitators are also suffering from acute problems. Public sector banks, which control 75% of Indian forex market, have always been under staffed and governed by bureaucratic rules.
The market for derivatives other than forward contracts is very shallow. Many of the banks reason it out to be as a result of corporate reluctance and lack of information and technology. Most of the banks in public sector do not merge the forex and money operation and they do not treat their forex operation as a separate profit centre. This bred inefficiency in their working which has affected the corporate sector.
The corporates have been recommended to look strategically into their exposure and take prudent decision in hedging. This decision should be backed by professional treasurers, an efficient back office and good forecasting techniques. They have been asked to go in for various other derivatives that are flexible and cost effective. The banking sector has been recommended to recruit specialised personnel for the job with latest technology to deal in the market. They should start providing variety of other derivatives to the industry. They should also merge their money market and forex operation and treat is as a separate profit centre.
These all measures will definitely make the forex market deep and vibrant, which will make the work easier for corporates in dealing with the currency exposure.
“We have to sleep with one eye open”
Managing director of an Indian company with investments in Indonesia.
This was in reference to the Indonesian rupiah crash which followed the nearly 100 percent, Thai currency plunge after the baht’s free float last July with the Indonesian currency in downward spiral and interest rates shooting northwards, Indian companies with investment in South-east Asia are in the midst of the maelstrom and are desperately scrambling to get a grip of this unprecedented situation even as they wonder: what next?
If only they could have got the wind of the disaster things would have been bit different for them. The spate of Southeast Asian currency plunge has sent warning signals to the developing economies to set their level in order to face crisis.
Companies have to set their house in order and give a micro as well as macro look at the currency exposure which they are facing. With increase in volume of business in external sector, companies should make themselves tuned to the dynamics of foreign exchange (currency) market.
1.1 Currency RISK MANAGEMENT
An asset or a liability or an expected future cash flow stream (whether certain or not) is said to be afflicted with currency risk when currency movement changes (for better or for worse) the home currency value.
There is always a possibility of the exchange rate changing between the home and foreign currencies, interest rate differentials widening and inflationary effects amounting, to an adverse reaction for the expected cash flows . The concept of currency risk also emanates when an investor is planning to diversity his portfolio internationally to improve the risk- return trade off by taking advantage of the relative correlation among risks on assets of different countries. This involves investing in a variety of currencies whose relative values may fluctuate , it involves taking currency risks.
The foreign exchange market is psychological in nature. A large number of transactions are speculative in nature which depends upon expectations of a large number of participants.
People tend to hitch their expectations to one fundamental.
For example, they might look at the money supply in the USA. The logic is that an increase in money supply will result in :
Þ An increase in inflation
Þ FED squeezing money
Þ Interest rate rising
Þ Dollar becoming more attractive for holding.
But this event of money supply could also lead to a different series of outcomes an shown by the following logic.
According to fisherman equation,
Nominal rate = Real rate + Inflation rate. An increase in inflation would mean the interest rates would be higher. Higher interest rates on bond and equity prices would make them less lucrative and thus lead to a bearish effect. There would be a selling pressure on the dollar and hence the exchange rates would tend to move against the dollar.
Dealings in foreign exchange market is said to be around $ 1000 billion each day. Out of this sizeable chunk of more than 75% is on speculative basis. And this speculation has been pointed out as major cause of the south Asian turmoil.
Since the mid 1970’s a potent mix of fast-interlocking market and a revolution in information technology has increased the speed, frequency and magnitude of price changes in the financial markets, which, in turn have multiplied both opportunity and risk for the CFO.
Not, surprisingly, in the developed markets, much innovative energy has been devoted to devising instruments and mechanisms that enable CFO to survive this turbulence. While creative financial engineering has opened the floodgates for a deluge of products, two broad classes of risk management have evolved.
The first deploys a natural hedge to manage exposure to risk. Typically, this means explicitly factoring in risk perceptions when choosing the components of the financing mix. Or, to neutralise exposures in a particular market, a natural hedge could involve taking a counter position in another market. The second class of tools however creates a synthetic hedge by utilising specific financial instruments. Notably, derivatives.
1.2 Problems in Indian foreign exchange market
Our foreign exchange market suffers from several constraints.
i) There are a lot of ceilings on open positions and gaps and hence there is a virtual absence of market making and position trading.
ii) There is prohibition of initiating transactions in the cross currency in the overseas market.
iii) Besides the forward contracts, there is no free access to the other products like futures, swaps, etc. The market lacks the required liquidity and depth for the derivatives to be economically viable.
2. Literature review
2.1 THE NATURE OF EXPOSURE AND RISK
The value of a firm’s assets, liabilities and operating income vary continually in response to changes in economic and financial variables such as exchange rates, interest rates, inflation rates, relative prices and so forth. The impact of every financial decision on the value of the firm is uncertain and various options can be evaluated in terms of their risk return characteristics.
The nature of uncertainty can be illustrated by a number of commonly encountered situations. An appreciation of the value of a foreign currency (or equivalently, a depreciation of the domestic currency)., increases the domestic currency value of a firm’s assets and liabilities denominated in the foreign currency receivable and payables, bank deposits and loans etc. It will also change domestic currency cash flows from exports and imports. An increase in interest rates reduces the market value of a portfolio of fixed rate bonds and may increase the cash outflow on account of interest payments. Acceleration in the rate of inflation may increase the value of unsold stocks, the revenue from future sales as well as the future costs of production. Thus the firm is “exposed” to uncertain changes in a number of variables in its environment.
Let us begin with the definition of foreign exchange exposure.
Foreign exchange (Currency) exposure is the sensitivity of the real value of a firm’s assets, liabilities or operating income, expressed in its functional currency, to unanticipated changes in exchange rates.
Note the following important points about this definition.
Values of assets, liabilities or operating income are to be denominated in the functional currency of the firm. This is the primary currency of the firm and in which its financial statements are published. For most firms it is the domestic currency of their country.
Exposure is defined with respect to the real values i.e. values adjusted for inflation. While theoretically this is the correct way of assessing exposure, in practice due to the difficulty of dealing with an uncertain inflation rate this adjustment is often ignored i.e. exposure is estimated with reference to changes in nominal values.
The definition stresses that only unanticipated changes in exchange rates are to be considered. The reason is that markets will have already made an allowance for anticipated changes in exchange rates. For instance, an exporter invoicing a foreign buyer in the buyer currency into the price. A lender will adjust the rate of interest charged on the loan to incorporate an allowance for the expected depreciation. From an operational point of view, the question is how do we separate a given change in exchange rate into its anticipated and unanticipated components since only the actual change is observable? One possible answer is to use the forward exchange rate as the exchange rate expected by the “market” to rule at the time the forward contract matures. Thus suppose that the price of a pound sterling in terms of rupees for immediate delivery (the called spot rate) is Rs. 60.000 while the one months forward rate is Rs. 60.20. We can say that the anticipated depreciation of the rupee is 20 paise per pound in one month. If a month later, the spot rate turns out to be Rs. 60.30 there has been an unanticipated depreciation of 10 paise per pound.
In contrast to exposure which is a measure of the response of value to exchange rate changes, foreign exchange risk is defined as.
The variance of the real domestic currency value of assets, liabilities or operating income attribute to unanticipated changes in exchange rates.
In other words, risk is a measure of the extent of variability in the values of assets etc. due to unanticipated changes in exchanges rates.
2.2 Classification of Foreign Exchange Exposure and Risk
Three types of foreign exchange exposure and risk can be distinguished depending upon the nature of the exposed item and the purpose of exposure estimation. These are as follows.
This is a measure of the sensitivity of the home currency value of assets and liabilities which are denominated in foreign currency, to unanticipated changes in exchange rates, when the assets or liabilities are liquidated.
Transaction exposure can arise in three ways:
* A currency has to be converted in order to make or received payment for good s and services.
* A currency has to be converted to repay a loan or make an interest payment (or, conversely, receive a repayment or an interest payments) or.
* A currency has to be converted to make a dividend payment.
Suppose a firm receives an export order. It fixes a price, manufactures the product, makes the shipment and gives 90 days credit to the buyer who will pay in his currency. A company has acquired a foreign currency receivable, which will be liquidated before the next balance sheet date. The exposure affects cash flows during the current accounting period. If the foreign currency has appreciated between the day the receivable was booked on the day the payment was received, the company makes exchange gain which may have tax implications. In a similar fashion, interest payments and principal repayments due during the accounting period create transaction exposure. Transaction risk can be defined as a measure of uncertainty y in the value of assets and liabilities when they are liquidated.
Also called accounting Exposure is the exposure on assets and liabilities appearing in the balance sheet but yet to be liquidated. Translation risk is the related measure of variability.
The key difference between transaction and translation exposure is that the former involves actual movement of cash while the latter has no direct effect on cash flows. (This is true only if there are no tax effects arising out of translation gains and losses).
Translation exposure arises when a parent multinational company is required to consolidate a foreign subsidiary’s statements from its functional currency into the parent’s home currency. Thus suppose an Indian company has a U.K subsidiary. At the beginning of the parents financial year the subsidiary has real estate, inventories and cash valued at pound 1,000,000, pound 200,000 & pound 150,000 respectively. The spot rate is Rs. 60 per pound sterling. By the close of the financial year, these have changed to pound 1,200,000, pound 205000 and pound 160,000 respectively. However during the year, there has been a drastic depreciation of the pound to Rs. 56. If the parent is required to translate the subsidiary’s balance sheet from pound sterling into rupees at the current exchange rate, it has “suffered” a translation loss. Note that no cash movement is involved since the subsidiary is not to be liquidated. Also note that there must have been a translation gain on the subsidiary’s liabilities.
There is broad agreement among theorists that translation losses and gains are only notional accounting losses and gains. The actual numbers will differ according to the accounting practices followed and depending upon the tax laws, there may or may not be tax implications and therefore real gains or losses. Accountants and corporate treasurers however do not fully accept this view. They argue that even though no cash losses or gains are involved, translation does affect the published financial statements and hence may affect market valuation of the parent company’s stock. Whether investors indeed suffer from “translation illusion” is an empirical question. Some evidence from studies of the valuation of American multinationals seems to indicate that investors are quite aware of the notional character of these losses and gains and discount them in valuing the stock. for Indian multinational, translation exposure is a relatively less important consideration since the law does not require translation and consolidation of foreign subsidiaries financial statement s with those of the parent companies.
Unanticipated exchange rate changes not only affect assets and liabilities but also have significant impact on future cash flows from operations. Operating Exposure is a measure of the sensitivity of future cash flow and profits of a firm to unanticipated exchange rate changes.
Consider a firm that is involved in producing goods for export and or import substitutes. It may also import a part of its raw materials, components etc. A change in exchange rate (s) gives rise to a number of concerns for such a firm.
1. What will be the effect on sales volume if prices are maintained? If prices are changed? Should prices be changed? For instance, a firm exporting to a foreign market might benefit from reducing its foreign currency price to the foreign customers following an appreciation of the foreign currency. A firm that produces import substitutes may contemplate an increase in it domestic currency price to its domestic customers without hurting its sales.
2. Since a part of the inputs are imported, material costs will increase following a depreciation of the home currency.
3. Labour costs may also increase if cost of living increases and wages have to be raised.
4. Interest costs on working capital may rise if in response to depreciation the authorities resort to monetary tightening.
In general, an exchange rate change will affect both future revenues as well as operating costs and hence the operating income. As we will see later, the net effect depends upon the complex interaction of exchange rate changes, relative inflation rates at home and abroad, price elasticities of export and import demand and supply and so forth. Operating exposure and the related risk are extremely difficult to analyse, estimate and hedge against.
2.3 THE INDIAN FOREX MARKET
Indian foreign exchange market as compared with their American and European counterparts is till in its infants. The post liberalisation period has witnessed many exchange controls been lifted and introduction of few “hedging” tools like cross currency option, Range forwards, currency swaps etc. which provide a degree of flexibility to corporates in using the forex markets effectively. The Rupee has been made fully convertible on current account accepting the article VIII status laid down by IMF. This step has seen increased volume of trade in the Indian forex market.
Tarapore committee has put the proposal for capital account convertibility. It proposes to deregulate the foreign exchange by year 2002 in three phases.
2.4 PRESENT STATUS
Exchange control in India is administered by the Reserve Bank of India, which is empowered by the Foreign exchange regulation Act. The figure shows the players involved in the foreign exchange market from administrative point of view.
Regulation Act, 1973
Govt. of India
Reserve Bank of India
Foreign Exchange Dealers
Association of India
Full Fledged Restricted
Administration of Foreign Exchange in India.
The foreign exchange market in India functions with a three-tier structure which includes (1) Reserve Bank of India, at the apex level, (ii) authorised dealers/money changers conducting foreign exchange trading activities, and (iii) customers which include exporters/importer, corporates and other foreign exchange earners like NRI’s etc.
The market is highly influenced by State Bank of India and Reserve Bank of India because of their Sheer Size. The RBI constantly intervenes to keep the rupee from appreciating and is responsible for highly liquid spot market as it is a last resort buyer of dollars.
The forward market in India is fairly liquid and quotes are easily available up to six months. The RBI prohibits any international speculative access to rupee.
2.5 SIZE AND DEPTH OF THE MARKET
The daily turnover in the Indian Foreign exchange market is over US $400 million that is dominated by dealings in dollars. The foreign exchange reserve of $30 million provides the market with enough liquidity.
2.6 INDIAN EXCHANGE CONTROLS
Exchange Controls refer to the regulation, restrictions, guidelines that a country issues with respect to foreign exchange transactions. In the absence of any exchange control one would expect to do anything with the foreign exchange reserves that the company has-convert to any other currency, speculate, buy or sell option, freely export foreign exchange etc. etc.
In India, forward contract is the single largest product which the companies employ as a tool to manage their foreign exchange risks, though the cost has changed over the period of time. Before LERMS (liberalised exchange rate management system) importers rushed to book forward contracts expecting a devaluation of Re against US$. The cost was as high as 18% in Feb.’92. The cost of the forward premium came down sharply reflecting a more stable foreign exchange markets.
The Indian exchange market do not provide frequent quotations for ore than 6 months so for any long term forward cover rollover of the contract after every 6 months is needed. Rollover means cancellation of the old contract and re-booking of 6-month forward contract. Under this, care should be taken to cancel the old contract and re-book the next at the time when the cost of rebooking is least i.e. forward dollar is relatively cheap.
Further, in December 1994, RBI has allowed the corporates to bet on the third currency movement even if one does not have an underlying transaction exposure in the “third currency”. This means that a corporate with an underlying exposure in Dollar-Re can bet on the Dm-Dollar rate and book a forward contract for Dm against Re and on the maturity may change Dm to Dollar at the spot rate. This has been allowed as Indian Re has been pegged with US$ and there has not been many fluctuations on which the companies could speculate. There can be other ways to take advantage of this RBI circular. Consider an importer with $ payable after 6 months. He may buy $ forward against Yen (third currency) and after 6 months may buy Yen against Rupee at the spot rate. This position may be taken if the company expects Yen to depreciate against the Dollar within these 6 months. Nevertheless the speculative attempts to earn profits may also backfire to give losses if the exchange rate moves in the opposite direction. RBI has also made it obligatory upon the banks, which extend the third currency cover, to maintain “initial” and “variation” margins before offering such a facility. This has been done to avoid any default risk.
Another peculiar feature of ‘The Indian Exchange Control is that the “hedging” can be put through in case of transaction and translation exposures only. Economic exposures cannot be hedged.
Cross Currency option was introduced on 1st Jan. 1994, under which companies could enter option contract for hedging non-dollar exposure against dollar. As for now Rupee option does not exist in India. Essar Gujarat has been one of the innovative corporates who discovered this new concept and has benefited considerably by writing option in Dm- Dollar in Jan 1994. Indian Exchange controls do not allow cancellation of cross currency options in parts and once the option is cancelled it cannot be re-booked, unlike forwards. In the overseas markets minimum lot traded is $ 3m whereas Indian corporate by for lesser amount, this increases the premium paid by them for the option. Recently, ANZ Grindlay has offered to arrange a loan of $ 50m to Ranbaxy by making effective use of call and put options to defend both the parties against unfavourable movements in exchange rates.
Cross currency forward cover for importers who have taken $ loan for their imports but receive goods invoiced in say a Dm. They can enter forward cover for the delivery of Dm against the currency of loan i.e. -$. This is the cross currency forward cover.
Some of the foreign Exchange controls are that export of foreign currency is not permitted, unless it has special RBI permission. “Exchange controls also they list the permitted currency“ and a method of payment as approved by RBI for translation across the countries. It also contains guidelines relating to “ Foreign currency assets” covering permission as for repatriation of capital profits dividends etc. Exchange controls also allow FC to be retained up 50% (in case of EOU EPZ units) and 25% (in case of ordinary exporters with banks in Indian and also abroad under EEFC a/c and FCA a/c. Exchange controls also state under-invoicing and over-invoicing of exports as a crime attracting penal provisions. Further, all sale proceeds in FC should come into the country within 180 days. RBI permission is required for any extension beyond 180 days. In case of failure to get RBI’s nod, the tax and other export incentives are not provided to the exporters.
Further, exchange controls give details and guidelines for different accounts for NRI and foreign investors such as Ordinary Non- Resident Rupee a/c, Non-Resident External; Rupee a/c FCNR (B) a/c etc.
Introduction of complex hedging tools like futures, options is still a long way to go, Recently, the government lifted the ban on futures, option trading in equity (stocks) after 40 years, This could be regarded as a step ahead to come closer to introduction of more complex tools in the currency markets in India. In the near future Standard Chartered plans to introduce rupee-based derivatives in India subject to the clearance and approval by exchange controls, with many companies now making use of different tools effectively, the Indian foreign exchange markets are moving ahead towards more relaxations and towards making the foreign exchange markets more vibrant and versatile, IDBI is one of the most active user of financial derivatives in Indian market. It made considerable savings over the last two year by using the entire range of products available in Indian forex markets.
2.7 FINANCIAL DERIVATIVES USED IN INDIAN MARKET
A derivative instrument is commonly defined as one whose price is derived from an underlying quantity that could be an interest or an exchange rate (in this case exchange rate) we refer to derivatives of money and foreign exchange market prices as “financial derivatives”.
The history of using financial derivatives to hedge foreign exchange exposures by corporates in India is fairly recent. Early 90s’ witnessed few foreign currency call options written by some Indian corporates. The limited use and general lack of interest in the available instruments can be explained by the fact that dependence on external sources of funding was very limited and the external sector wasn’t really developed.
But after liberalisation and current account convertibility, the whole scenario has changed. Risk management has under gone a paradigm shift, new financial derivatives have been allowed in the market to provide for exposures arising out of increased business activity in the external sector. We shall discuss the various hedging tools is operative.
2.7.1 FORWARD CONTRACTS
The Definition: A forward contract is simply an agreement to buy or sell foreign exchange at a stipulated rate at a specified time in the future. It is a contract calling for settlement beyond the spot date. The time frame can vary from a few days to many years.
Instrument: A forward contract locks you to a particular exchange rate, thereby insulating the CFO from exchange rate fluctuations. In India, the forward contract has been the most popular instrument employed by corporates to cover their exposures, and thereby, offset a known future cash outflow. Forward contracts are usually available only for periods up to 12 months. Forward premiums are governed purely by demand and supply, which provide corporates with arbitrage opportunities. The premiums in this market are quoted till the last working day of the month.
Internationally, the forward premiums or discounts reflect the prevailing interest rate differentials. Arbitrage opportunities are therefore limited. As a rule, a currency with a higher interest rate trades at a discount to a currency with a lower interest state. Since there is a forward market available for longer periods, the forward cover for foreign exchange exposures can stretch up to five years. The premiums or discounts are quoted on a month-to-month basis. That is, from the spot date to exactly one month, or two months, or even a year. AN EXAMPLE.A corporate has to make a payment of US $I million on March 31, 1998. They can book a forward contract today, and fix the exchange rate at which he will make the payment. Assuming that the dollar-rupee spot rate is Rs 36.40, and the forward premium on the dollar for delivery on March31. 1998, is Rs 0.30 the effective exchange rate for the remittance becomes Rs 36.70 (36,40+30).
The Regulations: In March 1992, in order to provide operational freedom to corporates, the unrestricted booking and cancellation of forward contracts, for all genuine exposures, whether trade-related or not, was permitted.
In January 1997, the RBI allowed the banks to quote rupee forward premiums for more than six months. This has resulted in the development of a local forward market for up to one year. However, as the link between the local money market and the foreign exchange markets is not strong, and as prices and determined by demand and supply, activity in the long -term forward market has been limited.
2.7.2 FORWARD TO FORWARD CONTRACTS
The Definition: A forward -to-forward contract is a swap transaction that involves the simultaneous sale and purchase of one currency for another, where both transactions are forward contracts. It allows the company to take advantage of the forward premium without locking on to the spot rate. The Instrument: A forward-to-forward contract is a perfect tool for corporates that want to take advantage of the opposite movements in the spot and the forward markets. By locking in the forward premium at a high or low level now, CFOs can defer locking on to the spot rate to the future when they consider the spot rate to be moving in their favour.
However, a forward-to forward contract can have serious cash-flow implications for a corporate. Before booking a forward-to forward contract a CFO should carefully examine his cash flow position bearing in mind the immediate loss that he would make if the spot rate did not move in his favour.
The Example. An exporter believes that forward premiums are high, and will move down before the end of December 1997. Also he expects the spot rate to depreciate in the next few months. Then, the optimal strategy would be to lock in the high forward premium now, and defer the spot rate to a future date. So, he opts for a forward-to forward contract for end December. 1997, to end March of 1998. Paying a premium of say a Rs 0.64 By entering into such a contract the exporter has the opportunity to lock on to the spot rate any time till December 31, 1997. Alternatively, if the three-month premium between end-December and end-March moves below the Rs 0.64 level he can cancel the contract and book his profits.
Forward -to-forward contracts
Company A is due to receive the payment for goods exported three months earlier. Currently, three-month forward premiums are high, but Company A expects the sport rate to depreciate further.
The forward-to-forward pay-off matrix
Lack in the Current Premium By Purchasing A Forward-To-Forward Contact
Better Than Simple Forward, But Worse Than Uncovered Strategy
Choose The Spot Rate Within A Stipulated Time-Period, Thus Determining Effective Forward Rate
Better than Uncovered Strategy,
At the end of the months, Convert Export Proceeds to Rupee at the Effective Forward Rate
SF : Simple Forward Rate EF: Forward-to-Forwar