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Foreign exchange risk

IntroductionThe gradual liberalization of Indian economy has resulted in substantial inflow of

foreign capital into India. Simultaneously dismantling of trade barriers has alsofacilitated the integration of domestic economy with world economy. With theglobalization of trade and relatively free movement of financial assets, riskmanagement through derivatives products has become a necessity in India also, likein other developed and developing countries. As Indian businesses become moreglobal in their approach, evolution of a broad based, active and liquid forexderivatives markets is required to provide them with a spectrum of hedging productsfor effectively managing their foreign exchange exposures. The global market forderivatives has grown substantially in the recent past.

Evolution of the forex derivatives market in India:

This tremendous growth in global derivative markets can be attributed to a numberof factors. They reallocate risk among financial market participants, help to makefinancial markets more complete, and provide valuable information to investorsabout economic fundamentals. Derivatives also provide an important function ofefficient price discovery and make unbundling of risk easier.In India, the economic liberalization in the early nineties provided the economicrationale for the introduction of FX derivatives. Business houses started activelyapproaching foreign markets not only with their products but also as a source ofcapital and direct investment opportunities. With limited convertibility on the tradeaccount being introduced in 1993, the environment became even more conducive forthe introduction of these hedge products.The Indian economy saw a sea change in the year 1999 whereby it ceased to be aclosed and protected economy, and adopted the globalization route, to become apart of the world economy. In the pre-liberalisation era, marked by State dominated,tightly regulated foreign exchange regime, the only risk management tool availablefor corporate enterprises was, lobbying for government intervention. With theadvent of LERMS (Liberalised Exchange Rate Mechanism System) in India, in1992, the market forces started to present a regime with steady price volatility asagainst the earlier trend of long periods of constant prices followed by sudden, largeprice movements.The unified exchange rate phase has witnessed improvement in informational and

operational efficiency of the foreign exchange market, though at a halting pace. Inthe corporate finance literature, research on risk management has focused on thequestion of why firms should hedge a given risk. The literature makes the importantpoint that measuring risk exposures is an essential component of a firm's riskmanagement strategy. Without knowledge of the primitive risk exposures of a firm, itis not possible to test whether firms are altering their exposures in a mannerconsistent with theory. The spurts in foreign investments in India have led tosubstantial increase in the quantum of inflows and outflows in different currencies,with varying maturities. Corporate enterprises have had to face the challenges of theshift from low risk to high risk operations involving foreign exchange. There wasincreasing awareness of the need for introduction of financial derivatives in order to

enable hedging against market risk in a cost effective way. Earlier, the Indiancompanies had been entering into forward contracts with banks, which were the

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Authorised Dealers (AD) in foreign exchange. But many firms preferred to keep theirrisk exposures un-hedged as they found the forward contracts to be very costly.

RBI (Reserve Bank of India) Regulations:The exposures for which the rupee forward contracts are allowed under the existing

RBI notification for various participants are as follows:

I. Residents:1.Genuine underlying exposures out of trade/business2.Exposures due to foreign currency loans and bonds approved by RBI3.Receipts from GDR issued4.Balances in EEFC accounts

II. Foreign Institutional Investors:1.They should have exposures in India2.Hedge value not to exceed 15% of equity as of 31 March 1999 plus increase in

market value/ inflows

III. Nonresident Indians/ Overseas Corporates:1.Dividends from holdings in a Indian company2.Deposits in FCNR and NRE accounts3.Investments under portfolio scheme in accordance with FERA or FEMA

Foreign Exchange Risk Management: Process & Necessity:Firms dealing in multiple currencies face a risk (an unanticipated gain/loss) onaccount of sudden/unanticipated changes in exchange rates, quantified in terms ofexposures. Exposure is defined as a contracted, projected or contingent cash flowwhose magnitude is not certain at the moment and depends on the value of theforeign exchange rates. The process of identifying risks faced by the firm andimplementing the process of protection from these risks by financial or operationalhedging is defined as foreign exchange risk management. This paper limits its scopeto hedging only the foreign exchange risks faced by firms.

Kinds of Foreign Exchange ExposureRisk management techniques vary with the type of exposure (accounting oreconomic) and term of exposure. Accounting exposure, also called translationexposure, results from the need to restate foreign subsidiaries financial statements

into the parents reporting currency and is the sensitivity of net income to thevariation 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 particularcurrency, is sensitive to unexpected changes in foreign currency. Currencyfluctuations affect the value of the firms operating cash flows, income statement,and competitive position, hence market share and stock price. Currency fluctuationsalso affect a firm's balance sheet by changing the value of the firm's assets andliabilities, accounts payable, accounts receivables, inventory, loans in foreigncurrency, investments (CDs) in foreign banks; this type of economic exposure iscalled balance sheet exposure. Transaction Exposure is a form of short termeconomic exposure due to fixed price contracting in an atmosphere of exchange-rate

volatility.

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Necessity of managing foreign exchange riskA key assumption in the concept of foreign exchange risk is that exchange ratechanges are not predictable and that this is determined by how efficient the marketsfor foreign exchange are. Research in the area of efficiency of foreign exchangemarkets has thus far been able to establish only a weak form of the efficient market

hypothesis conclusively which implies that successive changes in exchange ratescannot be predicted by analysing the historical sequence of exchange rates.However, when the efficient markets theory is applied to the foreign exchangemarket under floating exchange rates there is some evidence to suggest that thepresent prices properly reflect all available information.This implies that exchangerates react to new information in an immediate and unbiased fashion, so that no oneparty can make a profit by this information and in any case, information on directionof the rates arrives randomly so exchange rates also fluctuate randomly. It impliesthat foreign exchange risk management cannot be done away with by employingresources to predict exchange rate changes.

Hedging as a tool to manage foreign exchange riskThere is a spectrum of opinions regarding foreign exchange hedging. Some firmsfeel hedging techniques are speculative or do not fall in their area of expertise andhence do not venture into hedging practices. Other firms are unaware of beingexposed to foreign exchange risks. There are a set of firms who only hedge some oftheir risks, while others are aware of the various risks they face, but are unaware ofthe methods to guard the firm against the risk. There is yet another set of companieswho believe shareholder value cannot be increased by hedging the firms foreignexchange risks as shareholders can themselves individually hedge themselvesagainst the same using instruments like forward contracts available in the market ordiversify such risks out by manipulating their portfolio. There are some explanationsbacked by theory about the irrelevance of managing the risk of change in exchangerates. For example, the International Fisher effect states that exchange rateschanges are balanced out by interest rate changes,the Purchasing Power Paritytheory suggests that exchange rate changes will be offset by changes in relativeprice indices/inflation since the Law of One Price should hold. Both these theoriessuggest that exchange rate changes are evened out in some formor the other.Also, the Unbiased Forward Rate theory suggests that locking in theforward exchange rate offers the same expected return and is an unbiased indicatorof the future spot rate. But these theories are perfectly played out in perfect marketsunder homogeneous tax regimes. Also, exchange rate-linked changes in factors like

inflation and interest rates take time to adjust and in the meanwhile firms stand tolose out on adverse movements in the exchange rates. The existence of differentkinds of market imperfections, such as incomplete financial markets, positivetransaction and information costs, probability of financial distress, and agency costsand restrictions on free trade make foreign exchange management an appropriateconcern for corporate management. It has also been argued that a hedged firm,being less risky can secure debt more easily and this enjoy a tax advantage (interestis excluded from tax while dividends are taxed). This would negate the Modigliani-Miller proposition as shareholders cannot duplicate such tax advantages. The MMargument that shareholders can hedge on their own is also not valid on account ofhigh transaction costs and lack of knowledge about financial manipulations on the

part of shareholders. There is also a vast pool of research that proves the efficacy of

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managing foreign exchange risks and a significant amount of evidence showing thereduction of exposure with the use of tools for managing these exposures.

Foreign Exchange Risk Management Framework

Once a firm recognizes its exposure, it then has to deploy resources in managing it.Aheuristic for firms to manage this risk effectively is presented below which can bemodified to suit firm-specific needs i.e. some or all the following tools could be used.

1. Forecasts:After determining its exposure, the first step for a firm is to develop aforecast on the market trends and what the main direction/trend is going to be on theforeign exchange rates. The period for forecasts is typically 6 months. It is importantto base the forecasts on valid assumptions. Along with identifying trends, aprobability should be estimated for the forecast coming true as well as how much thechange would be.

2. Risk Estimation: Based on the forecast, a measure of the Value at Risk (theactual profit or loss for a move in rates according to the forecast) and the probabilityof this risk should be ascertained. The risk that a transaction would fail due tomarket-specific problems should be taken into account. Finally, the Systems Riskthat can arise due to inadequacies such as reporting gaps and implementation gapsin the firms exposure management system should be estimated.

3. Benchmarking: Given the exposures and the risk estimates, the firm has to setits limits for handling foreign exchange exposure. The firm also has to decidewhether to manage its exposures on a cost centre or profit centre basis. A costcentre approach is a defensive one and the main aim is ensure that cash flows of afirm are not adversely affected beyond a point. A profit centre approach on the otherhand is a more aggressive approach where the firm decides to generate a net profiton its exposure over time.

4. Hedging: Based on the limits a firm set for itself to manage exposure, the firmsthen decides an appropriate hedging strategy. There are various financialinstruments available for the firm to choose from: futures, forwards, options andswaps and issue of foreign debt. Hedging strategies and instruments are explored ina section.

5. Stop Loss: The firms risk management decisions are based on forecasts whichare but estimates of reasonably unpredictable trends. It is imperative to have stoploss 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 theforeign exchange rates for appropriate measure to be taken.

6. Reporting and Review: Risk management policies are typically subjected toreview based on periodic reporting. The reports mainly include profit/ loss status onopen contracts after marking to market, the actual exchange/ interest rate achievedon each exposure and profitability vis--vis the benchmark and the expectedchanges in overall exposure due to forecasted exchange/ interest rate movements.

The review analyses whether the benchmarks set are valid and effective in

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controlling the exposures, what the market trends are and finally whether the overallstrategy is working or needs change.

Hedging Strategies / Instruments:A derivative is a financial contract whose value is derived from the value of someother financial asset, such as a stock price, a commodity price, an exchange rate, aninterest rate, or even an index of prices. The main role of derivatives is that theyreallocate risk among financial market participants,help to make financial marketsmore complete. This section outlines the hedging strategies usingderivatives withforeign exchange being the only risk assumed.

1.Forwards: A forward is a made-to-measure agreement between two parties tobuy/sell a specified amount of a currency at a specified rate on a particular date inthe 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 buythat currency in future say for import), it can hedge by buying the currency forward.E.g if RIL wants to buy crude oil in US dollars six months hence, it can enter into aforward 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. Inthis example the downside is an appreciation of Dollar which is protected by a fixedforward contract. The main advantage of a forward is that it can be tailoredto the specific needs of the firm and an exact hedge can be obtained. On thedownside, these contracts are not marketable, they cant be sold to another partywhen they are no longer required and are binding.

2. Futures: A futures contract is similar to the forward contract but is more liquidbecause it is traded in an organized exchange i.e. the futures market. Depreciationof a currency can be hedged by selling futures and appreciation can be hedged bybuying futures. Advantages of futures are that there is a central market for futureswhich eliminates the problem of double coincidence. Futures require a small initialoutlay (a proportion of the value of the future) with which significant amounts ofmoney can be gained or lost with the actual forwards price fluctuations. Thisprovides a sort of leverage. The previous example for a forward contract for RILapplies here also just that RIL will have to go to a USD futures exchange topurchase standardised 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 futurescontract is limited i.e. only standard denominations of money can be boughtinstead of the exact amounts that are bought in forward contracts.

3.Options:A currency Option is a contract giving the right, not the obligation, to buyor sell a specific quantity of one foreign currency in exchange for another at a fixedprice; called the Exercise Price or Strike Price. The fixed nature of the exercise pricereduces the uncertainty of exchange rate changes and limits the losses of opencurrency positions. Options are particularly suited as a hedging tool for contingentcash flows, as is the case in bidding processes. Call Options are used if the risk isan 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 oilin USD in 6 months, if RIL buys a Call option (as the risk is an upward trend in dollar

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rate), i.e. the right to buy a specified amount of dollars at a fixed rate on a specifieddate, there are two scenarios. If the exchange rate movement is favourable i.e thedollar depreciates, then RIL can buy them at the spot rate as they have becomecheaper. In the other case, if the dollar appreciates compared to todays 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

4.Swaps: A swap is a foreign currency contract whereby the buyer and sellerexchange equal initial principal amounts of two different currencies at the spot rate.The buyer and seller exchange fixed or floating rate interest payments in theirrespective swapped currencies over the term of the contract. At maturity, theprincipal amount is effectively re-swapped at a predetermined exchange rate so thatthe parties end up with their original currencies. The advantages of swaps are thatfirms with limited appetite for exchange rate risk may move to a partially orcompletely 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 anexport oriented company that has entered into a swap for a notional principal of USD1 mn at an exchange rate of 42/dollar. The company pays US 6months LIBOR to thebank and receives 11.00% p.a. every 6 months on 1st January & 1st July, till 5years. Such a company would have earnings in Dollars and can use the same to payinterest for this kind of borrowing (in dollars rather than in Rupee) thus hedging itsexposures.

Significance of the Study:India had earlier followed a tightly regulated foreign exchange regime. Theliberalisation of the Indian economy started in 1991. The 1992-93 Budget providedfor partial convertibility of Indian Rupee in current accounts and, in March 1993, theRupee was made fully convertible in current account. Demand and supply conditionsnow govern the exchange rates in our foreign exchange market. A fast developingeconomy has to cope with a multitude of changes, ranging from individual andinstitutional preferences to changes in technology, in economic policies, inregulations etc. Besides, there are changes arising from external trade and capitalaccount interactions. These generate a variety of risks, which have to be managed.There has been a sharp increase in foreign investment in India. Multi-national andtransnational corporations are playing increasingly important roles in Indian

business. Indian corporate units are also engaging in a much wider range of crossborder transactions with different countries and products. Indian firms have alsobeen more active in raising financial resources abroad. All these developmentscombine to give a boost to cross-currency cash flows, involving different currenciesand different countries. The corporate enterprises in India are increasingly alive tothe need for organised fund management and for the application of innovativehedging techniques for protecting themselves against attendant risks. Derivativesare the tools that facilitate trading in risk.The foreign exchange market is still evolving and corporate enterprises are goingthrough the movements in transition from a passive to an active role in riskmanagement. There is no organized information available on how the corporate

enterprises in India are facing this challenge. It is in this context that a review of theperceptions and concerns of the corporates, in relation to derivatives and of their

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initiatives in tuning the organisational set up to acquire and adopt the requisite skillsin risk management, assumes significance. Appropriate policy and other measurescan then be taken to accelerate the process of further development of foreignexchange market and also upgrade foreign exchange risk management (FERM) withhigher professionalism and increased effectiveness.

Objectives of the Study:Main objectives of the study are,1. To ascertain the FERM practices, and product usage, of Indian non-financialcorporate enterprises.2. To know the attitudes, perceptions and concerns of Indian firms towards FERM.3. To understand the level of awareness of derivatives and their uses, among thefirms.4. To ascertain the organisation structure, policymaking and control process adoptedby the firms, which use derivatives, in managing foreign exchange exposure.

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. For now, Indian companies are actively hedging their foreign exchanges

risks with forwards, currency and interest rate swaps and different types of options

such as call, put, cross currency and range-barrier options. The high use of forward

contracts by Indian firms also highlights the absence of a rupee futures exchange in

India. However, the Dubai Gold and Commodities Exchange in June, 2007

introduced Rupee- Dollar futures that could be traded on its exchanges and hadprovided another route for firms to hedge on a transparent basis. There are fears

that RBIs ability to control the partially convertible currency will be subdued by this

introduction but this issue is beyond the scope of this study. The partial convertibility

of the Rupee will be difficult to control if many exchanges offer such instruments and

that will be factor to consider for the RBI.

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