18-08-2012, 01:37 PM
Corporate Hedging for Foreign Exchange Risk in India
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1. Introduction
In 1971, the Bretton Woods system of administering fixed foreign exchange rates was
abolished in favour of market-determination of foreign exchange rates; a regime of
fluctuating exchange rates was introduced. Besides market-determined fluctuations,
there was a lot of volatility in other markets around the world owing to increased
inflation and the oil shock. Corporates struggled to cope with the uncertainty in
profits, cash flows and future costs. It was then that financial derivatives – foreign
currency, interest rate, and commodity derivatives emerged as means of managing
risks facing corporations.
In India, exchange rates were deregulated and were allowed to be determined by
markets in 1993. The economic liberalization of the early nineties facilitated the
introduction of derivatives based on interest rates and foreign exchange. However
derivative use is still a highly regulated area due to the partial convertibility of the
rupee. Currently forwards, swaps and options are available in India and the use of
foreign currency derivatives is permitted for hedging purposes only.1
This study aims to provide a perspective on managing the risk that firm’s face due to
fluctuating exchange rates. It investigates the prudence in investing resources towards
the purpose of hedging and then introduces the tools for risk management. These are
then applied in the Indian context. The motivation of this study came from the recent
rise in volatility in the money markets of the world and particularly in the US Dollar,
due to which Indian exports are fast gaining a cost disadvantage. Hedging with
derivative instruments is a feasible solution to this situation.
This report is organised in 6 sections. The next section presents the necessity of
foreign exchange risk management and outlines the process of managing this risk.
Section 3 discusses the various determinants of hedging decisions by firms, followed
by an overview of corporate hedging in India in Section 4. Evidence from major
Indian firms from different sectors is summarized here and Section 5 concludes.
1 Sourced from www.rbi.org
2. Foreign Exchange Risk Management: Process & Necessity
Firms dealing in multiple currencies face a risk (an unanticipated gain/loss) on
account of sudden/unanticipated changes in exchange rates, quantified in terms of
exposures. Exposure is defined as a contracted, projected or contingent cash flow
whose magnitude is not certain at the moment and depends on the value of the foreign
exchange rates. The process of identifying risks faced by the firm and implementing
the process of protection from these risks by financial or operational hedging is
defined as foreign exchange risk management. This paper limits its scope to hedging
only the foreign exchange risks faced by firms.
2.1 Kinds of Foreign Exchange Exposure
Risk management techniques vary with the type of exposure (accounting or
economic) and term of exposure. Accounting exposure, also called translation
exposure, results from the need to restate foreign subsidiaries’ financial statements
into the parent’s reporting currency and is the sensitivity of net income to the
variation in the exchange rate between a foreign subsidiary and its parent.
Economic exposure is the extent to which a firm's market value, in any particular
currency, is sensitive to unexpected changes in foreign currency. Currency
fluctuations affect the value of the firm’s operating cash flows, income statement, and
competitive position, hence market share and stock price. Currency fluctuations also
affect a firm's balance sheet by changing the value of the firm's assets and liabilities,
accounts payable, accounts receivables, inventory, loans in foreign currency,
investments (CDs) in foreign banks; this type of economic exposure is called balance
sheet exposure. Transaction Exposure is a form of short term economic exposure due
to fixed price contracting in an atmosphere of exchange-rate volatility.
The most common definition of the measure of exchange-rate exposure is the
sensitivity of the value of the firm, proxied by the firm’s stock return, to an
unanticipated change in an exchange rate. This is calculated by using the partial
derivative function where the dependant variable is the firm’s value and the
independent variable is the exchange rate (Adler and Dumas, 1984).
2.2 Necessity of managing foreign exchange risk
A key assumption in the concept of foreign exchange risk is that exchange rate
changes are not predictable and that this is determined by how efficient the markets
for foreign exchange are. Research in the area of efficiency of foreign exchange
markets has thus far been able to establish only a weak form of the efficient market
hypothesis conclusively which implies that successive changes in exchange rates
cannot be predicted by analysing the historical sequence of exchange rates.(Soenen,
1979). However, when the efficient markets theory is applied to the foreign exchange
market under floating exchange rates there is some evidence to suggest that the
present prices properly reflect all available information.(Giddy and Dufey, 1992).
This implies that exchange rates react to new information in an immediate and
unbiased fashion, so that no one party can make a profit by this information and in
any case, information on direction of the rates arrives randomly so exchange rates also
fluctuate randomly. It implies that foreign exchange risk management cannot be done
away with by employing resources to predict exchange rate changes.
2.2.1 Hedging as a tool to manage foreign exchange risk2
There is a spectrum of opinions regarding foreign exchange hedging. Some firms feel
hedging techniques are speculative or do not fall in their area of expertise and hence
do not venture into hedging practices. Other firms are unaware of being exposed to
foreign exchange risks. There are a set of firms who only hedge some of their risks,
while others are aware of the various risks they face, but are unaware of the methods
to guard the firm against the risk. There is yet another set of companies who believe
shareholder value cannot be increased by hedging the firm’s foreign exchange risks as
shareholders can themselves individually hedge themselves against the same using
instruments like forward contracts available in the market or diversify such risks out
by manipulating their portfolio. (Giddy and Dufey, 1992).
There are some explanations backed by theory about the irrelevance of managing the
risk of change in exchange rates. For example, the International Fisher effect states
that exchange rates changes are balanced out by interest rate changes, the Purchasing
Power Parity theory suggests that exchange rate changes will be offset by changes in
relative price indices/inflation since the Law of One Price should hold. Both these
theories suggest that exchange rate changes are evened out in some form or the other.
Also, the Unbiased Forward Rate theory suggests that locking in the forward
exchange rate offers the same expected return and is an unbiased indicator of the
future spot rate. But these theories are perfectly played out in perfect markets under
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 to lose out on
adverse movements in the exchange rates.
The existence of different kinds of market imperfections, such as incomplete financial
markets, positive transaction and information costs, probability of financial distress,
and agency costs and restrictions on free trade make foreign exchange management an
appropriate concern for corporate management. (Giddy and Dufey, 1992) It has also
been argued that a hedged firm, being less risky can secure debt more easily and this
enjoy a tax advantage (interest is excluded from tax while dividends are taxed). This
would negate the Modigliani-Miller proposition as shareholders cannot duplicate such
tax advantages. The MM argument that shareholders can hedge on their own is also
not valid on account of high 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 managing foreign
exchange risks and a significant amount of evidence showing the reduction of
exposure with the use of tools for managing these exposures. In one of the more
recent studies, Allayanis and Ofek (2001) use a multivariate analysis on a sample of
S&P 500 non-financial firms and calculate a firms exchange-rate exposure using the
ratio of foreign sales to total sales as a proxy and isolate the impact of use of foreign
currency derivatives (part of foreign exchange risk management) on a firm’s foreign
exchange exposures. They find a statistically significant association between the
absolute value of the exposures and the (absolute value) of the percentage use of
foreign currency derivatives and prove that the use of derivatives in fact reduce
exposure.
2 Based on Giddy, Ian H and Dufey, Gunter,1992, The Management of Foreign Exchange Risk
2.3 Foreign Exchange Risk Management Framework3
Once a firm recognizes its exposure, it then has to deploy resources in managing it. A
heuristic for firms to manage this risk effectively is presented below which can be
modified to suit firm-specific needs i.e. some or all the following tools could be used.
Forecasts: After determining its exposure, the first step for a firm is to
develop a forecast on the market trends and what the main direction/trend is
going to be on the foreign exchange rates. The period for forecasts is typically
6 months. It is important to base the forecasts on valid assumptions. Along
with identifying trends, a probability should be estimated for the forecast
coming true as well as how much the change would be.
Risk Estimation: Based on the forecast, a measure of the Value at Risk (the
actual profit or loss for a move in rates according to the forecast) and the
probability of this risk should be ascertained. The risk that a transaction would
fail due to market-specific problems4 should be taken into account. Finally, the
Systems Risk that can arise due to inadequacies such as reporting gaps and
implementation gaps in the firms’ exposure management system should be
estimated.
Benchmarking: Given the exposures and the risk estimates, the firm has to
set its limits for handling foreign exchange exposure. The firm also has to
decide whether to manage its exposures on a cost centre or profit centre basis.
A cost centre approach is a defensive one and the main aim is ensure that cash
flows of a firm are not adversely affected beyond a point. A profit centre
approach on the other hand is a more aggressive approach where the firm
decides to generate a net profit on its exposure over time.
Hedging: Based on the limits a firm set for itself to manage exposure, the
firms then decides an appropriate hedging strategy. There are various financial
instruments available for the firm to choose from: futures, forwards, options
and swaps and issue of foreign debt. Hedging strategies and instruments are
explored in a section.
Stop Loss: The firms risk management decisions are based on forecasts which
are but estimates of reasonably unpredictable trends. It is imperative to have
stop loss arrangements in order to rescue the firm if the forecasts turn out
wrong. For this, there should be certain monitoring systems in place to detect
critical levels in the foreign exchange rates for appropriate measure to be
taken.
Reporting and Review: Risk management policies are typically subjected to
review based on periodic reporting. The reports mainly include profit/ loss
status on open contracts after marking to market, the actual exchange/ interest
rate achieved on each exposure, and profitability vis-à-vis the benchmark and
the expected changes in overall exposure due to forecasted exchange/ interest
rate movements. The review analyses whether the benchmarks set are valid