Currency Risk Management in Indian Banks
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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-Forward Rate
DS : Sport Rate at The Time of Delivery
The Definition: An option is a contract that gives the holder the right, but not the obligation to buy (call) or sell (put) a specified underlying instrument at a fixed price-called the strike-or exercise price before, or at, a future date. The option holder has to compensate the writer (the issuer of the instrument) for this right, and the cost bome is called the premium, or the option price.
The premium should be adequate for the risk bome by the writer and yet, from the holder's point of view, must be worth paying. If the option contains a provision to the effect that it can be exercised any time before the expiry of the contract, it is termed an American contract if it can be exercised only on the expiry date, it is termed a European contract.
The Instrument: Options can be used for hedging currency exposures when a corporate is not sure which way the currency is going to move. By entering into an option contract, the CFO gets the best of both worlds his downside is restricted to the premium that he pays, and he enjoys an unlimited upside. For the buyer of an option, the gains are unlimited and the losses are limited .For the writer of the option, the losses are unlimited and the gains are limited to the extent of the premium he gains.
The value of a currency option consists of two components.
* The intrinsic value, or the amount, by which an option is in the money. A call option whose exercise price is below the current spot price if the underlying instrument, or a put option whose exercise price is above the current spot price of the underlying instrument, is said to be in the money.
* The extrinsic value or the total premium of an option less the intrinsic value. It is also known as the time value or the volatility value. As the expiry time increases, the premium on an option also increases. However, with each passing day the rate of increase in the premium decreases. Conversely, as an option approaches expiry the rate of decline in its extrinsic value increases. The decline is known as the time decay. Therefore, the more volatile a currency, the higher will be its option value.
* The Example: Company X is importing machinery for DM I million. At the time the deal was struck, the DM was trading at 1.7600 to the dollar. Payment has to be made by April 30, 1998, The DM has already depreciated to 1.7700, and the company has made a tidy profit. The CFO believes that the dollar will continue to gain against the DM, but he would not like to lose the gains already made. Therefore, he buys an in-the-money DM call option by a paying an upfront premium of 2.01 percent. If on April 30, 1998, the DM is above 1.7900, he will let the option lapse, on the other hand, if the DM is 1,7200 he would exercise the option, and buy DM at the pre-determined rate of 1.7600.
The Regulations: In January 1994. Corporates were permitted to use currency options as hedging products. In the absence of a rupee yield curve, rupee-based currency options were not permitted since the pricing of such options would have been arbitrary. Therefore the banks were allowed to offer only cross currency options on a fully covered basis. And the option could be cancelled only once. CFOS were not permitted to re book options against the same exposure. They could however, hedge the exposure using the forward market.
Company A has to import equipment three months hence but is unsure of which way the dollar-rupee exchange rate will move.
The Currency options pay-offs
Purchase A dollar
CallOption By Paying
Strike Price ($)
Dollar Appreciations: Do Not Exercise Option And Buy Dollars Spot
Dollar Depreciations: Exercise Option And Buy Dollars At Strike Price
2.7.4 CURRENCY SWAPS
The Definition: A currency swap is a legal agreement between two parties to exchange the principal and interest rate obligations or receipts in different currencies. The transaction involves two counter parties who exchange specific amounts of two currencies at the outset, and repay them over time according to a pre determined rule that reflects both the interest payment and the amortisation of the principal amount.
The in vestment currency swaps unable us to exploit their comparative advantge using funds in one currency to obtain savings in other currency. Usually banks with a global presence act as intermediaries in swap transactions, helping to bring together the two parties, sometimes, banks themselves may become counter parties to the swap deal. Alternatively banks can hedge themselves by taking positions in the futures markets.
Currency swaps also permit corporates to switch their loans from a particular currency in another depending on their expectations of the future movement of the currency and interest rates. Thus, it offers tremendous flexibility to CFOs seeking to hedge the risks associated with a particular currency. A CFO no longer has to live with a bad decision; if he has selected a wrong currency for his overseas funding operations a currency swap can do the damage.
The Regulation: from august 1997 the banks have been permitted to offer currency swaps to corporates by booking the transaction overseas, or on a back to back basis. Unwinding from such hedge transactions and the payment of upfront premium, as well as the charges incidental to the transaction can also be effected without the prior approval of the RBI. However, the onus is on the banker to ensure that such hedge transactions are done purely for liability management- and not as stand -alone deals.
Company A borrows in dollar, Company B, in rupees.
They enter into a currency swap.
Receive Dollar Payments From Company B
2.7.5 range forwards
Definition: A rage forward contract involves simultaneous purchase and sale of call and put options on the same principal amount and of the same maturity but at different strike price. Here the hedger pays a premium on
Purchase of option and receives a premium on the sale of the option. The net cost of the contract is the difference between the two premiums. The strike price of the two options may be adjusted to bring down the net cost to the hedger even to zero.
Example: Now, let us look at how a range forward is different from a forward cover. An Indian importer has to make a DM payment at the end of three months to a German company. To hedge his risks, the importer can take a three-month forward cover for three months. Assuming that the spot rate of one DM is Rs 23.25, he can take a forward cover at an annualised cost of 9.01 per cent. While he would get no benefit from any up ward movement of the Rs DM rate, he would incur no additional costs if the rate rises above the Rs 23.25 mark. But whatever he the spot rate after three months the importer has an obligation to but DM, at the forward rate. The importer has another option of going for a plain vanilla USD/DM cross currency call option at a price which is nearer to the forward price at say 1,5000. The importer pays a premium of 1.85 per cent for the same. While his down side risk is pegged at the amount of premium paid. He enjoys an unlimited upside gain potential. AS direct rupee options are not allowed in India, the importer needs to cover his dollar exposure by taking a Rs/USD forward cover.
Alternative if the importer feels that the 1.85 per cent premium he pays for a plain vanilla option is higher he can enter into a range forward contract, which would allow him to simultaneously purchase and sell options at different strike prices. In a range forward contract the importer buys a DM call option at a porter buys a DM call option at a strike price of 1,500 and pays a premium of 1.85 per cent for the same In addition to this, he also sells a DM put option at a strike price of 1,5250 and receives a premium of 1,41 percent. As a result, his net hedging costs would therefore, fall to 0.44 percent (1.85 percent minus 1.41 percent). This is the range within which both the parties operate, If on maturity the strike price lies within the range, the option will not be exercised by either of the parties.
This contract is structured in such a way that on maturity if the spot price is below 1.5000 the importer has a right to buy DM at the strike price of 1.5000. This importer by buying an option caps his downside loss at 15000 for which he pays a premium. Similarly if the price on maturity is above 1.5250, the importer has an obligation to buy at the strike price of 1.5250. Hence his gain potential is capped at 1.5250 for which it receives a premium. The importer is protected from adverse rate fluctuations. If the price on maturity is within the range, the importer buys DM at the spot rate.
The Regulation: In September, 1996 the RBI's Exchange Control Manual was amended to allow the banks to offer range forwards to corporates to hedge their foreign exchange exposures, provided that premium paid by the corporate was non negative.
1.5250 ----- Put
Option Not exercised
2.7.6 Ratio-range forwards
A ratio-range forward is a modification of the range forward in a ratio -range forward the importer will sell a put option not for the entire amount but for a part of it. Thus by varying the amount of the put option sold, he can vary the level of participation in the upside gains, If the importer has $10 million exposure, he would buy calls of $ 10 mn but sells puts on only $7 mn. The strike price may be adjusted so that the net out flow of premium is minimized or is zero., This way the importer will not lose the entire upside potential but only a part of it. He thus shares the upside gain potential with the bank. The ratio of sharing or participation will depend on the agreement between the bank and the customers.
2.8 OTHER methods OF EXCHANGE RISK MANAGEMENT
2.8.1 Denomination in Local Currency
The exchange risk can be totally avoided of the transaction is denominated in local currency. In such a case the exchange risk will be borne by the other party to the transaction. For instance, if exports from Indian are invoiced in Indian rupees the obligation of the importer is to pay a fixed sum of rupees. The exporter is not affected by any movement in exchange. The importer, on the other hand, will he bearing the exchange risk entirely. He may have to pay more in terms of the currency of his country if that currency depreciates (or rupee appreciates). Similarly if an import into India is denominated in Indian rupees. The importer is free form exchange risk but it is borne fully by the exporter abroad.
Invoicing in local currency depends upon the relative bargaining capacity of the importer and exporter and the status of the currency in the international market. It may be noted that most of the foreign trade of Indian is denominated in foreign currency especially in currencies like US dollars, pound sterling, Deutsche mark and Japanese Yen. Denomination in rupees was found in trade with countries with which India had entered into bilateral trade agreements.
Denomination of the transaction in the currency of the importer or the exporter puts the other party at a disadvantage. To strike a balance, the transaction may be invoiced partly in the currency of the exporter's country and partly in the currency of the importer's country. Such a measure results only in sharing of the exchange loses between the two parties. It does not completely avoid the exchange risk. Similarly, denominating the transaction in a third currency, which a relatively stable (e.g. export from Indian to Indonesia is denominated neither in rupees nor in rupiah, but in US dollars) will only result spreading the exchange risk between parties.
2.8.2 Foreign Currency Accounts
To a trader who engages in both exports and imports or to a manufacturer exporter who imports sizable portion of raw materials components the exchange risk can be minimised of an account is maintained abroad, in the currency of trade through which all transactions can be routed. The arrangement has a dual advantage for the rule.
i) Since exports can pay for imports he is exposed no exchange risk only for the net balance.
ii) In normal course, the bank will apply baying rate the exports and selling rate for imports with the usual spread between the rates towards margin. The less of exchange in converting from foreign currency into local currency is avoided.
iii) In India under the Exchange Earners Foreign Currency (EEFC) account scheme the beneficiary of an inward remittance is entitled to retain in foreign currency up to 25% of the remittance received. The entitlement is 50% for 100% export oriented units and units in export-processing zones. The account holder can use the balance in this account for all purposes permitted in the exchange control manual, including for imports. Thus the loss of exchange in conversion can be avoided.
Reserve Bank of India permits exporters with good track record and net exchange earning of not loss than Rs 4 crores, to maintain foreign currency accounts or abroad subject to certain terms and conditions. The scheme is explained in the chapter or Export promotion
2.8.3 Leads and Lags
Exporters and importers keep making estimates as to whether the currency will weaken (devalued) or strengthen (revalued) in future. According to these expectations they may like to hasten or postpone the time of receipt or payment of foreign currency. This timing of payment of foreign currency depending upon the expectation of its change in value is know it as “leads and lags.
When the foreign currency is expected to be devalued, the exporter would press for payment earlier than the normal. This is because if the receives payment in foreign currency after devaluation, the amount he receives in rupee terms will be less. On the other hand, when the currency is expected to be revalued, the importer who has to pay in foreign currency would settle the debt earlier than the normal date. There by he would be paying less it terms of rupees when compared to the amount he will have to pay after the expected revaluation materialises. In both the case the exporter importer is said to ‘ lead' the payment.
When the foreign currency is expected to be revalued, the exporters would likes to delay the payments. Nor would they book forward contracts. If they receive payment after the revaluation the value in terms of rupees would be higher. Conversely when the foreign currency is expected to be devalued, the importers would like to delay the payment so that they may pay less in rupee terms, this postponing the payment is know as ‘lag'.
When the foreign currency is facing the threat of devaluation the exporters would secure early payment while importers would delay their payments. There fore, there is an increase in supply and decrease in demand for the foreign currency. This will further aggravate the forces weakening the currency. If the currency faces imminent revaluation exporters postpone payments while importers hasten their payments, the result is that the forces at work its strengthening the currency are further strengthened. Thus, the effect of ‘leads' and lags' is to further aggravate the forces causing change in the exchange rate of the currency.
As per the exchange control regulations in India payments, for exports and imports should be completed within six months from the date of shipment. Therefore the period up to which the exporters and importers can indulge in leads and lags' is restricted to six month.
3. RESARCH METHODOLOGY
3.1 OBJECTIVE OF THE RESEARCH
The objective of the research has been to study.
1. The attitude of Indian corporates towards risk arising out of foreign exchange (currency) exposure.
2. The ways and means adopted by banks in helping the corporates deal with their foreign exchange exposure. It would also include the problems and limitations faced by the banks, which ultimately has an affect on corporate exposures.
It has been undertaken to draw inferences which could prove the hypothesis of my study.
It has been much of a preliminary research with the main objective to study the problems faced by the Indian corporates in the currency market. As corporates deal through the banks, the problems faced by the banks also affect the corporates.
3.2 DATA AQUISITION METHOD
The research has been based on data acquired from the various companies and banks including Reserve Bank of India.
Data Type consists of facts, motives and opinions have been extracted through open-ended questions and other information though close ended questions.
3.3 SOURCES OF DATA
The data has been collected both through primary as well as secondary sources.
(i) Secondary Sources: - Data through secondary sources have been collected from journals published by Reserve Bank of India and other commercial banks like State Bank of India UTI Bank etc. Internet also provided some important information. The objective of the secondary data collection has been to get consolidated information on the foreign exchange dealings and transactions in India. The usage of secondary data has been minimal in the research.
(ii) Primary Source: - The objective of the primary source data collection has been to extract information on corporate view of their currency risk management and their dealing strategy.
Primary data has been collected through self-administered questionnaire, the response of which has been had by interviewing financial executive of various firms and officials from various banks.
3.4 Method of collection of data
Formalised questionnaires were used to collect the data. It contained both open-ended and close-ended questions. Bankers were asked few open-ended questions where as corporates were asked closed ended questions with checklist and multiple choice answers.
3.5 SAMPLING METHOD
The universe undertaken for the study are all the Indian companies which have a foreign exchange turnover above Rs. 50 crores per annum and commercial banks which deal in foreign exchange and have been nominated by Reserve Bank of India as Authorised Dealers in foreign exchange. The frame for the population has been companies with forex turnover of above Rs. 50 crores per annum and having their offices in Delhi.
Sample Size: As it was impossible to interview all the elements in the universe, I selected few corporates and banks as my sample size. There were many hindrances in getting appointments with financial executives, which further brought down my sample size. Finally I selected 20 corporates and 6 banks as my sample size.
The research undertaken has been based on the main assumption that.
“Currency Risk management has very few takers in Indian corporates.”
My contention is that currency risk management is at a nascent stage and has very few corporates dealing with it.
The main hypothesis is backed by the following hypothesis.
Hypothesis - I
* Indian importers do not go in for hedging even when the US dollar is at a premium.
Hypothesis - II
* Indian exporters do no hedge their exposures because of confidence in rupee not appreciating.
Hypothesis - III
* Indian companies going in for hedging are very conservative in their approach to currency risk management.
Hypothesis - IV
* Indian companies are not ready to face the situation, which may arise as a result of opening up of the Indian foreign exchange market.
Hypothesis - V
* Indian banking sector is inefficient in providing flexible hedging solutions to corporate forex exposure.
Hypothesis - VI
* Indian banks do not take currency risk management as a specialised job.
The analysis of the report has been done on the basis of questions put to the companies and banks to prove the hypothesis.
The analysis of the research has been divided into two parts. The first part of the analysts tries to prove the hypothesis in respect of the importers and exporters and companies involved both in importing and exporting. The second part of the analysis tries to prove the hypothesis taken in respect of banks.
PART I: ANALYSIS ON INDUSTRY
The distribution of the respondents (companies), according to their status is as follows:
No. Of Respondents
Foreign Exchange Turnover
The forex turnover of the companies was mostly within Rs. 200 crores. Companies and their forex turnover range are shown in cross tabulation form:
Turnover in (Rs. crs.)
500 and above
70% of the companies use dollars as currency for foreign exchange. This proves the dependence of the Indian economy on dollar. Mark and pound follows for behind with 12.5% and 10% respectively.
95% of the companies had exposure on revenue account while rest 5% had on both (i.e. revenue as well as capital) account. No company had its exposure solely on capital account. Capital account, in this context means foreign loan in terms of external commercial borrowings.
TESTING OF HYPOTHESIS
The assumption that forms the hypothesis of the project is that currency risk management has very few takers in Indian corporates. This hypothesis has been proved in various steps by taking up the other hypothesis, which together proves the main hypothesis.
HYPOTHESIS - I
The assumption in this hypothesis is that Indian importers do not go in for hedging even when the dollar is at a premium.
The importers face a constant danger of higher cash outflow but they do not try to hedge their risk.
(N.B. Here the word ‘importers' is meant for companies that only have foreign currency outflow)
Dynamics: I have tried to prove the hypothesis by asking the respondents (i.e. importers) about the risk policy and their strategy to counter expected higher cash out flow as a result of rupee depreciation that is shown in forward dollar premium. The importers were also asked about their reasons for not going in for hedging. Those who have gone in for hedging have been asked about their hedging strategy.
* 5 out of 7 importers do not hedge their foreign currency outflow.
* These 5 companies have no currency risk policy that justifies their stand.
* Different importers give different reason for not hedging their exposure. They have more than one reason for their stand which has been shown in chart 4.4.
* Only 2 out of 7 importers hedged their cash outflow. Both these importers fully hedged their outflow which justified their risk policy of Insurance. Both these companies used forward contracts with the reason that it is convenient to use forward contract.
* 77% of the non-hedgers had, RBI's intervention during rupee depreciation, as one of the reasons.
* 62% of the non-hedgers had forward covers being unnecessary cost, as one of the reasons.
* 72% of the companies with exposure between Rs. 50 to 100 crores found their exposures insufficient, as one of their reasons.
* Both the importers who went in for hedging had their forex exposure above Rs. 200.
Hence hypothesis has been accepted.
HYPOTHESIS - II
The assumption in this hypothesis is that Indian exporters do not hedge their exposure because of confidence in rupee not appreciating.
The exporters are sure of rupee not gaining against dollar which is why they do not want to carry out hedging tactics for their exposure.
Dynamics: The exporters have been asked about the risk policy, their strategy towards their currency exposure and how they manage their cash inflow. They have been asked about their reasons for not hedging.
The finding shows that 78% of the exporting have no risk policy. It includes all the companies with turnover between Rs. 50-Rs. 100 crs. The chart 4. 6 show the risk policy of different exporting companies.
* 8 out 9 exporters do not hedge their foreign currency inflow. It means 95% of companies involved in exporting stay away from hedging.
Exporters not hedging
n The lone exporting company hedges only a part of its exposure. Its strategy is justified by its risk policy of insurance. The company's turnover is over Rs. 200 crores.
n The reasons given by the companies for not hedging are as follows.
No. of companies
1. Lack of awareness and confident of rupee not gaining
2. Insufficient revenue, unnecessary cost and confident of rupee not gaining
3. Unnecessary cost, wants to gain on open position and confident of rupee not gaining
4. Unnecessary cost and confident of rupee not gaining
5. Confident of rupee not gaining
6. Wants to gain through open position and confident of rupee not gaining
* We can see from the table that the most important reason for companies not going for hedging is the confidence that rupee shall not appreciate. Constant RBI's intervention to check rupee's appreciation has led to exporters keeping themselves away from currency risk management.
Hence the hypothesis has been accepted.
HYPOTHESIS - III
The assumption, which forms the hypothesis, is that the companies going in for hedging are very conservative in their approach to currency risk management.
The companies do not go in for experimentation and cost effective method for hedging.
Dynamics: To prove the hypothesis the hedgers have been questioned about their method of hedging, the reasons for not using instruments other than forward contracts, their participation in the hedging process and their calculation method.
Out of total number of 20 companies only 4 companies go in for hedging. The break up is shown in the following table:
No. Of Companies Hedging
* 1 out of 4 hedgers go in for complete hedging. The other 3 go in for partial hedging.
* 50% of the hedgers participate in the hedging process along with the banks. The other 50% stay away and leave it to the bank.
* The companies going in for hedging have the following break up in term of exposure.
n 50% of the hedgers go in for gross basis strategy for calculating their exposure. The other 50% base their exposure on netting out strategy.
n 80% of the companies involved in both import and export follow netting out strategy for calculation of their exposure.
n All the companies hedging their exposure go in for forward contracts as tool for hedging.
n 37.5% companies take forward contract because it is convenient in their dealing.
n 62.5% do not go in for other derivatives except for forward contracts because of lack of awareness and exposure.
* The forecasting techniques which the companies, going in for hedging, use are as follows:
No. Of Companies
Past trends and sentiments
* No of company base its forecasting technique on the fundamentals factors.
The fact that 80% of the companies choose netting out strategy (which is a risky technique) and 62% of the companies are unaware and unexposed or lack experience in adopting other derivatives speaks of the inefficiencies of these companies.
Thus the hypothesis that companies are conservative and inefficient in the dealing has been proved.
Hence the hypothesis has been accepted.
Hypothesis - IV
The assumption forming this hypothesis is that the Indian companies are not ready to face the situation that may arise as a result of opening up of the Indian foreign market i.e. when capital account convertibility shall be brought into play.
Dynamics: The companies have been asked about the importance they accord to their back office. They have been asked about the importance of currency risk management in near future and their strategy to face the situation arising out of the currency exposure in near future.
n Only 2 out of 20 companies have a back office functioning.
n Out of these 2 companies, 1 company has an independent back office functioning and other 1 have merged their front office with the back office.
n Both the companies having independent back office functioning have a forex turnover of over Rs. 500 crores.
n No exporting company has a back office functioning.
n 52.5% Important of currency risk management of the companies feel that the importance of currency risk management will increase in the near future, which in a way should increase the importance of back office. The table shows the break-up of the companies.
Out of the companies realising the importance of currency risk management only 42.85 % are in the process of equipping their company to face the situation. The break-up of the respondents strategy, who felt the importance of currency risk management shall increase, regarding equipping their offices are :
* 5 out of 7 importing companies foresee rupee devaluation in the near future.
* Out of these 5 companies only 1 company is in the process of equipping their office to face the situation. Rest other companies are dependent on RBI's intervention.
* The importing companies stand is justified by its opinion that Central bank's intervention does not act as a hindrances in the business. All the importers are of the same view.
From the analysis one can make out that very few companies, which realise the importance of currency risk management, are equipping their office to face the risk, and it is more so for the importing company which foresee a rupee devaluation.
Hence, the hypothesis has been accepted.
Analysis on Banking Sector
Analysis is based on the 6 banks from which I got the responses. The banks involved were both from the private sector as well as the public sector. The break up is as follows:
Public sector banks - 4
Private Sector banks - 2
Total - 6
The public sector banks led by the giant State Bank of India dominate the turnover in terms foreign exchange dealing. Chart 4.11 shows the distribution of forex turnover that takes place in the Indian foreign exchange market.
Hypothesis - V
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