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SUMMER INTERNSHIP, GAIL (INDIA) LIMITED, 2013
STUDY OF VARIOUS FOREIGN EXCHANGE
HEDGING INSTRUMENTS
MUKUND CHANDRAN, GREAT LAKES INSTITUTE OF
MANAGEMENT, CHENNAI
GAIL (INDIA) LIMITED
24/04/2013 – 10/06/2013
6/10/2013
SUMMER INTERNSHIP, GAIL (INDIA) LIMITED, 2013 P a g e | ii
A REPORT ON
STUDY OF VARIOUS FOREIGN EXCHANGE HEDGING
INSTRUMENTS
BY:
MUKUND CHANDRAN
GAIL (INDIA) LIMITED
DATE: 10-06-2013
SUMMER INTERNSHIP, GAIL (INDIA) LIMITED, 2013 P a g e | iii
A REPORT ON
STUDY OF VARIOUS FOREIGN EXCHANGE HEDGING INSTRUMENTS
BY:
MUKUND CHANDRAN
ROLL NO.: 14128
PGDM 2012-2014
GREAT LAKES INSTITUTE OF MANAGEMENT, CHENNAI
COMPANY GUIDE:
GAIL (INDIA) LIMITED
CA MAMTA GUPTA
SR. MANAGER (F&A)
FINANCE
FACULTY GUIDE:
GREAT LAKES INSTITUTE OF MANAGEMENT, CHENNAI
PROF. RS VEERAVALLI
DIRECTOR-PGXPM, CO-DIRECTOR GEMBA &
ASSOCIATE PROFESSOR
SUMMER INTERNSHIP, GAIL (INDIA) LIMITED, 2013 P a g e | iv
DECLARATION
I hereby declare that the Project Report “STUDY OF VARIOUS FOREIGN EXCHANGE
HEDGING INSTRUMENTS” is my own work to the best of my knowledge and belief. It
contains no material previously published or written by another person or material which to
substantial extent has been accepted for the award of any other degree, diploma or programme of
any other institute, except where due acknowledgement has been made in text.
MUKUND CHANDRAN Date: 10-06-2013
Roll No.: DM14128
Great Lakes Institute of Management, Chennai
SUMMER INTERNSHIP, GAIL (INDIA) LIMITED, 2013 P a g e | vi
CERTIFICATE
This is to certify that Project Work entitled “STUDY OF VARIOUS FOREIGN EXCHANGE
HEDGING INSTRUMENTS” is a piece of work done by Mr. MUKUND CHANDRAN under
my guidance and supervision for the partial fulfillment of Post Graduate Diploma in
Management, a Programme offered by Great Lakes.
To the best of my knowledge and belief the Project Report:
a. embodies the work of the candidate himself / herself
b. has duly been completed
c. fulfills the requirements of the Rules & Regulations relating to the
Summer Internship of the Institute.
d. is up to the standard both in respect to contents and language for
being referred to the examiner
Date: 10-06-2013
PROF. R S VEERAVALLI
DIRECTOR-PGXPM, CO-DIRECTOR GEMBA &
ASSOCIATE PROFESSOR
SUMMER INTERNSHIP, GAIL (INDIA) LIMITED, 2013 P a g e | vii
ACKNOWLEDGEMENT
With immense pleasure, I would like to present this project report for GAIL (India) Limited.
It has been an enriching experience for me to complete my summer training at GAIL, which
would not have possible without the goodwill and support of the people around. As a student
of GREAT LAKES INSTITUTE OF MANAGEMENT, CHENNAI I would like to express
my sincere thanks to all those who helped me during my training program.
Words are insufficient to express my gratitude towards CA Mamta Gupta (Senior Manager,
F&A) for giving me an opportunity to do my project work in the organization.
I am extremely thankful to my faculty guide Prof. R.S. Veeravalli for his valuable guidance and
support during and upon completion of this project.
Any omission in this brief acknowledgement does not mean lack of gratitude.
SUMMER INTERNSHIP, GAIL (INDIA) LIMITED, 2013 P a g e | viii
EXECUTIVE SUMMARY
India is now well-integrated with the world economy & moves in tandem with global
developments, both on the economic front as well as on the currency front. Since liberalization in
the early 1990s there have been a lot of changes in the Indian economy which have changed the
face of the Indian Financial Sector.
With the dismantling of trade barriers, business houses started actively approaching foreign
markets not only with their products but also to source capital and direct investment
opportunities. India Inc today has reached the scale and size of the global order and several
Indian organizations are today world leaders in their respective industries. Arriving on the global
scenario subjects corporations to diversified revenue streams in various geographies, thus leading
to invoicing in global currencies such as USD, GBP and EUR among others. Similarly, access to
various borrowing mechanisms and debt markets has also led to increased non-INR exposure on
books.
The objective of this project is to study and give a detailed description of the various hedging
instruments available in the Foreign Exchange market along with the different techniques used by
corporates.
SUMMER INTERNSHIP, GAIL (INDIA) LIMITED, 2013 P a g e | ix
TABLE OF CONTENTS
Acknowledgement vii
Executive Summary viii
List of Diagrams x
1.0 Introduction: About the Company 1
2.0 Foreign Exchange Risk Management 8
3.0 Hedging Instruments 14
4.0 Research Methodology 22
5.0 Data Analysis 23
6.0 Conclusion 27
7.0 Bibliography 38
SUMMER INTERNSHIP, GAIL (INDIA) LIMITED, 2013 P a g e | x
LIST OF DIAGRAMS
Fig. 1.1 Highlights of GAIL (India) Limited for the financial year 2011-12. 5
Fig. 1.2 Major products and brands of GAIL (India) Limited. 6
Fig. 2.1 The foreign risk management framework adopted by corporates. 12
Fig. 3.1 The different hedging techniques available to corporates to use. 19
SUMMER INTERNSHIP, GAIL (INDIA) LIMITED, 2013 P a g e | 1
CHAPTER – 1
INTRODUCTION: ABOUT THE COMPANY
GAIL (INDIA) LIMITED
INTRODUCTION
GAIL (India) Limited is the largest state-owned natural gas processing and distribution
company headquartered in New Delhi, India. It has following business segments: Natural Gas,
Liquid Hydrocarbon, LPG Transmission, Petrochemical, City Gas Distribution, Exploration and
Production, GAILTEL and Electricity Generation. GAIL has been conferred with the Maharatna
status on 1 Feb 2013, by the Government of India. Currently only six other Public Sector
Enterprises (PSEs) enjoy this coveted status amongst all central CPSEs.
HISTORY
GAIL (India) Limited was incorporated in August 1984 as a Central Public Sector Undertaking
(PSU) under the Ministry of Petroleum & Natural Gas (MoP&NG). The company was previously
known as Gas Authority of India Limited. It is India's principal Gas transmission and marketing
company. The company was initially given the responsibility of construction, operation &
maintenance of the Hazira – Vijaypur – Jagdishpur (HVJ) pipeline Project. Between 1991 and
SUMMER INTERNSHIP, GAIL (INDIA) LIMITED, 2013 P a g e | 2
1993, three liquefied petroleum gas (LPG) plants were constructed and some regional pipelines
acquired, enabling GAIL to begin its gas transportation in various parts of India.
GAIL began its city gas distribution in New Delhi in 1997 by setting up nine compressed natural
gas (CNG) stations.
GAIL today has reached new milestones with its strategic diversification into Petrochemicals,
Telecom and Liquid Hydrocarbons besides gas infrastructure. The company has also extended its
presence in Power, Liquefied Natural Gas re-gasification, City Gas Distribution and Exploration
& Production through participation in equity and joint ventures. Incorporating the new-found
energy into its corporate identity, Gas Authority of India was renamed GAIL (India) Limited on
22 November 2002.
GAIL (India) Limited has shown organic growth in gas transmission through the years by
building large network of trunk pipelines covering length of around 11,000 kilometres (6,800
mi). Leveraging on the core competencies, GAIL played a key role as gas market developer in
India for decades catering to major industrial sectors like power, fertilizers, and city gas
distribution. Currently GAIL transmits more than 160 mmscmd of gas through its dedicated
pipelines and have more than 70% market share in both gas transmission and marketing.
SUMMER INTERNSHIP, GAIL (INDIA) LIMITED, 2013 P a g e | 3
VISION ELEMENTS
Leading Company: Be the undisputed leader in the natural gas market in India and a significant
player in the global natural gas industry, by growing aggressively while maintaining the highest
level of operating standards.
Natural Gas & Beyond: Focus on all aspects of the natural gas value chain and beyond
including exploration, production, transmission, marketing, extraction, processing, distribution,
utilization including petrochemicals and power and natural gas related infrastructure, products
and services.
Global Focus: Create and strengthen significant global presence to pursue strategic, attractive
opportunities that leverage GAIL‟s capabilities while effectively managing business risks.
Customer Care: Anticipate and exceed customer expectation through the provision of the
highest quality infrastructure, products and services.
Value Creation for all Stakeholders: GAIL will create superior value for all stakeholders
including shareholders, employees, business partners, surrounding communities and the nation.
Environmental Responsibility: GAIL is committed to operational excellence in all we do with a
focus on continuous efforts to improve environmental performance for ourselves and our
customers and will be sensitive to the needs of the environment in all our actions.
SUMMER INTERNSHIP, GAIL (INDIA) LIMITED, 2013 P a g e | 4
“Be the Leading Company in Natural Gas and Beyond,
with Global Focus, Committed to Customer Care,
Value Creation for all Stakeholders and Environmental Responsibility”
CORE ORGANISATION VALUES
Ethics: We are transparent, fair and consistent in dealing with all people. We insist on honesty,
integrity and trustworthiness in all our activities.
People: We believe that our success is driven by the commitment and excellence of our people.
We attract and retain result-oriented people who are proud of their work and are satisfied with
nothing less than the very best in everything that they do. We encourage individual initiative by
creating opportunities for our people to learn and grow. We respect the individual‟s rights and
dignity of all people.
Health, Safety and Environment: We promote highest levels of safety in our operation, health
of our employees and a clean environment. We strive for continuous development of the
communities in which we operate.
Customer: We strive relentlessly to exceed the expectations of our customers, both internal and
external. Our customers prefer us.
Shareholders: We meet the objectives of our shareholders by providing them superior returns
and value through their investments in us.
SUMMER INTERNSHIP, GAIL (INDIA) LIMITED, 2013 P a g e | 5
Technology: We believe technology is a key to the future success of our organization. We
advocate ‘best-in-class’ technologies.
HIGHLIGHTS 2011-12
Figure 1.1: Highlights of GAIL (India) Limited for the financial year 2011-12.
MAJOR FIGURES FOR GAIL GROUP COMPANIES
GAIL Group Companies account for:
About 3/4th
of the natural gas transmitted through pipelines in India
More than ½ of the natural gas sold in India
Almost 1/5th
(21%) of polyethylene produced in country
LPG produced for every 10th
LPG cylinder in the country
Pipeline transmission of around 1/4th
of the country‟s total LPG
Gas supply for about ½ of the country‟s fertilizer produced
12% + 10 Years CAGR (PAT)
TURNOVER: Rs. 40,281 Crore (US$ 7907 mn)
PBDIT: Rs. 6,247 Crore (US$ 1210 mn)
PBT: Rs. 5,340 Crore (US$ 1034 mn)
PAT: Rs. 3,654 Crore (US$ 708 mn)
16% + 10 Years (Turnover) CAGR
SUMMER INTERNSHIP, GAIL (INDIA) LIMITED, 2013 P a g e | 6
Gas supply for about ½ of the country‟s gas-based power generation
Operating more than 2/3rd
of country‟s CNG stations
More than ½ of country‟s piped natural gas supply
16%+ 10 year turnover CAGR
12%+ 10 year PAT CAGR
3900+ manpower asset
MAJOR PRODUCTS AND BRANDS
Figure 1.2: Major products and brands of GAIL (India) Limited.
CITY GAS DISTRIBUTION
• CNG: Automobiles
• PNG: Cooking, Water Heating, AC, Space Heating, Steam Generation, Power Generation, Dryers, Furnaces, Boilers
PETROCHEMICALS
• G-Lex: Pressure Pipes, OFC Ducts, Thin Films, Monofilament, etc.
• G-Lene: Wire and Cable, Pipe Coating, Injection Moulding, Film, Lamination
TELECOM
• GAILTEL: Bandwidth Leasing, Infrastructure Leasing
LIQUID HYDROCARBONS
• G-Propane: Manufacture of Textiles, Glass, Picture Tubes, Automobile, Bearings, Forging, Casting, Melting Industry, Refrigerant in AC etc.
• G-Pentane: Artificial Ice Formation, Low temperature thermometers, Pesticides, Production of iso and normal Pentane
SUMMER INTERNSHIP, GAIL (INDIA) LIMITED, 2013 P a g e | 7
MISSION STATEMENT
“To accelerate and optimize the effective and
economic use of Natural Gas and its fractions
to the benefit of national economy”
SUMMER INTERNSHIP, GAIL (INDIA) LIMITED, 2013 P a g e | 8
CHAPTER – 2
FOREIGN EXCHANGE RISK MANAGEMENT
INTRODUCTION
Firms that deal in multiple currencies when it comes to their business face a risk (unanticipated
gain/loss) on account of sudden changes in exchange rates that are unanticipated, quantified in
terms of exposure. In terms of Foreign Exchange, Exposure is defined as a contracted, projected
or contingent cash flow whose magnitude is not certain at the current moment and depends on the
value of the exchange rates.
So it is quite clear that the process which includes identifying such risks faced by the firm and the
subsequent process of the implementation of protection from these risks by financial and
operational hedging will be called foreign exchange risk management.
HEDGING
A hedge is an investment position which is taken with the intention of offsetting potential
losses/gains that may be incurred by another accompanying investment.
Simply put, Hedging is coming up with a way to protect yourself against a loss. Since you can
never really be sure what the market will do, hedging can be thought of as a way to reduce the
amount of loss you will incur in case of an unexpected happening.
SUMMER INTERNSHIP, GAIL (INDIA) LIMITED, 2013 P a g e | 9
TYPES OF FOREIGN EXCHANGE EXPOSURES
Foreign Exchange Exposures can be classified into three types, they are as follows:
(i) Transaction Exposure
(ii) Economic Exposure
(iii) Translation Exposure
ECONOMIC EXPOSURE:
It measures the impact of changes in exchange rates on the firm‟s cash flows and thus earnings.
In other words, Economic Exposure is the extent to which a firm‟s market value, in any particular
foreign currency, is sensitive to the unanticipated changes in exchange rates. The aforementioned
currency fluctuations affect the values of the firm‟s operating cash flows, income statement &
competitiveness with respect to the market, hence market share & stock price.
Another type of exposure which comes under the privy of the Economic Exposure is the Balance
Sheet Exposure. The currency fluctuations affect a firm‟s Balance Sheet by changing the value of
their assets & liabilities, accounts payables & receivables, debts in foreign currencies, inventory
and also investments in foreign banks(usually in the form of Current Deposits).
SUMMER INTERNSHIP, GAIL (INDIA) LIMITED, 2013 P a g e | 10
TRANSLATION EXPOSURE:
Also knows as Accounting Exposure. It measures the impact of changes in exchange rate on the
financial statements of the group of company.
In other words, it can be stated as the sensitivity of the net income of a group of companies to the
fluctuation in exchange rates between a foreign subsidiary and its parent company. It results from
the need to restate foreign subsidiaries‟ financial statements into the parent‟s reporting currency.
TRANSACTION EXPOSURE:
It refers to the sensitivity of the future cash transactions of the firm to changes in the current
exchange rates.
It is also sometimes seen as a short-term economic exposure.
FOREIGN RISK MANAGEMENT FRAMEWORK
Once the process of recognizing the exposures is done, a firm puts its valuable resources in
managing it. The usual tools used by the firms are as follows:
(I) Forecasts: The first step for a corporate is to come up with a forecast on the market
trends and to come up with a conclusion on what the main trend is going to be on the
exchange rates. The period of forecasts is usually 6 months. The most important thing
is to base the forecasts on valid assumptions rather than wild guessing.
(II) Risk Estimation: Using the forecast, a Value at Risk and the probability of this risk is
calculated. Value at Risk is the actual profit/loss for a move in rates according to the
SUMMER INTERNSHIP, GAIL (INDIA) LIMITED, 2013 P a g e | 11
forecast. Then, the Systems Risk that can arise due to inadequacies such as reporting
gaps and implementation gaps in the firms‟ system of exposure management is
estimated.
(III) Benchmarking: Knowing the exposures and the risk estimates, the firm has to come
up with limits for handling this exposure. It also has to decide whether it wants to
manage itself as a Cost Centre or Profit Centre basis. A Cost Centre approach is a
defensive approach with the aim of ensuring that the Cash Flows of the firm are not
adversely affected beyond a particular point. A Profit centre approach is a more
aggressive approach where in the firm decides to generate profits on the exposures
over a period of time.
(IV) Hedging: The firms decide upon an appropriate hedging strategy based on the limits
that they have set to manage the exposures. The various instruments available for the
firm are: Futures, Forwards, Options, Swaps & Issue of Foreign Debt.
(V) Stop Loss: In the above steps we have seen that the firms risk management decisions
are based on the forecasts which are nothing but estimates of unpredictable trends.
Therefore it is very necessary to have stop loss arrangements in place in order to
rescue the firm in case the forecasts turn out wrong.
(VI) Reporting and Review: These policies are usually subjected to review based on
periodic reporting. The reports include profit/loss status on open contracts after
marking to market, the actual exchange rate/interest rate achieved on the exposures
and profitability in relation to the benchmark and the expected changes in overall
exposure due to forecasted exchange/interest rate movements. The review analyses
SUMMER INTERNSHIP, GAIL (INDIA) LIMITED, 2013 P a g e | 12
whether the benchmarks were valid and effective in controlling exposures and finally
whether the overall strategy is working or needs change.
Figure 2.1: The foreign risk management framework adopted by corporates.
APPROACHES TO RISK MANAGEMENT
Once the risk has been identified, the management then shifts its focus on the mitigation of these
risks based on their approach towards the risk.
The different approaches that managements have towards risk management are as follows:
REPORTING AND REVIEW
STOP LOSS
HEDGING
BENCHMARKING
RISK ESTIMATION
FORECASTS
SUMMER INTERNSHIP, GAIL (INDIA) LIMITED, 2013 P a g e | 13
(i) Conservative Approach: Corporates having this approach don‟t want to assume any
risk and consequently are ready to forego any opportunity gains that might come their
way in due course. They prefer to lock themselves from both the averse and favorable
movements by hedging the exposure as soon as it is encountered. The up-side to this
kind of approach is that there is little chance of cash-flow destabilization as the yields
and costs of the transactions are known beforehand. The down-side is that it is highly
unlikely that it will lead to optimum costs or yields.
(ii) Moderate Approach: In this approach, the corporate opts for partial hedging of
exposures whenever the rates are attractive and benchmarks are achieved. Partial
hedging leaves the door open for the company to take advantage of the opportunity
gains, keeping a part of its exposure hedged so that any movement of the exchange
rate can help it to average out the total cost. This approach can turn out to be fruitful
provided the timing and quantum is properly evaluated.
(iii) Aggressive Approach: Corporates having this approach actively trade in the
currency markets through continuous re-bookings and cancellations of the forward
contracts. In pursuit of getting the best gains, they indulge in continuous buying and
selling of currencies. In this, the treasure functions like a profit centre rather than a
cost centre. Corporates having this kind of an approach have an appetite for risk as
this is a high risk-high reward approach.
(iv) Indifferent Approach: In this approach all the exposures are left un-hedged. This
approach is considered to be highly speculative, as everything is left to chance. The
risk of destabilizing of cash flows is the highest in this approach.
SUMMER INTERNSHIP, GAIL (INDIA) LIMITED, 2013 P a g e | 14
CHAPTER – 3
HEDGING INSTRUMENTS
INTRODUCTION TO DERIVATIVES:
A Derivative is a security whose price is derived from one or more underlying assets. The
common underlying assets are stocks, bonds, commodities, currencies, interest rates and market
indexes. A derivative is just a contract between two or more parties. The main role of derivatives
is to reallocate risk among market participants.
In the following section we will talk about hedging strategies used by corporates in India using
derivatives assuming foreign exchange risk as the only risk involved.
HEDGING INSTRUMENTS:
The different hedging instruments that can be used by corporates are as follows:
(i) Forwards
(ii) Futures
(iii) Options
(iv) Swaps
(v) Foreign Debts
SUMMER INTERNSHIP, GAIL (INDIA) LIMITED, 2013 P a g e | 15
FORWARDS: A forward contract in the foreign exchange market is one that locks in the
price at which a corporate can buy or sell a currency on a future date. It is also called as „Outright
Forward Currency Transaction‟, „FX Forward‟.
In this, the depreciation of the receivable can be hedged against by selling a currency forward.
Similarly if there is a risk of a currency appreciation, then it can be hedged by buying the
currency forward.
For Example, if GAIL wants to buy crude oil in Euros say a year down the line, it can enter into a
forward contract to pay INR and buy EUR and lock in a fixed exchange rate for INR-EUR to be
paid after a year irrespective of the actual INR-EUR exchange rate prevailing at the time. The
downside in this agreement will be an appreciation of dollar which has been protected by a fixed
forward contract.
The advantage with the forward contracts is the fact that they can be tailored to the needs of the
firm and an exact hedge suiting the corporate can be obtained. The only downside to these
contracts is their non-marketability; they can‟t be sold to another party.
FUTURES: A Futures contract is very similar to a Forward contract, the difference
lying in their tailor ability and liquidity. A Futures contract is more liquid in nature as it is traded
in the futures market which provides organized exchange. There is an advantage of futures, it
eliminates the problem of double coincidence due to the presence of a central futures market.
Trading in futures requires a small initial outlay which is a proportion of the value of the future,
which can help in gaining or losing significant amounts of money based on the actual forward
price fluctuations.
SUMMER INTERNSHIP, GAIL (INDIA) LIMITED, 2013 P a g e | 16
Using the same example used in the forward contracts, GAIL has to go a EUR futures exchange
to purchase standardized euro futures equal to the amount that they are willing to hedge as the
risk is that of appreciation of the euro. Here comes the disadvantage of the futures, its tailor
ability is limited as only standard denominations are provided by the futures market which is
different from the forwards in which exact amounts can be bought.
OPTIONS: A Currency Option is a contract which gives the right, not an obligation, to buy or
sell a specific quantity of one foreign currency in exchange for another at a fixed price which is
called the Strike/Exercise Price. Since, the exercise price is fixed in nature it reduces the
uncertainty of exchange rate fluctuations thus limiting the losses of open currency positions.
There are two types of Options: one is a Call Option and the other a Put Option.
Call Options are used if the risk involved is of an upward price trend of the currency, whereas Put
Options are used if the risk is that of a downward price trend of the currency.
Taking the same example, if GAIL buys a Call Option, as the risk is of upward trend in Euro rate,
they have the right to buy a specified amount of euros at a fixed rate on a particular date, there are
two possibilities. The first possibility is that of a favorable exchange rate movement i.e. the Euro
depreciates, then GAIL can buy Euros at the spot rate i.e. the prevailing rate since they have
become cheaper. The other possibility being, if the Euro appreciates compared to say the pre-
existing spot rate, GAIL can exercise the Call Option to purchase it at the agreed Exercise Price.
In both the cases GAIL is benefited by paying a lower price to purchase the Euro.
SUMMER INTERNSHIP, GAIL (INDIA) LIMITED, 2013 P a g e | 17
SWAPS: A Swap is a foreign currency contract wherein the buyer and the seller exchange
equal initial principal amounts of two different currencies at the spot rate. Over the term of the
contract the buyer and the seller exchange fixed or floating rate of interest payments in their
respective swapped currencies. And at maturity the principal amount is effectively re-swapped at
a predetermined exchange rate so that both the parties end up with their respective currencies.
The advantages of swaps are that firms with limited appetite for exchange rate risk can achieve a
partially or completely hedged position using this, while leaving their underlying borrowing
intact. Another advantage is that swaps also allow firms to hedge their floating interest rate risk
on top of the exchange rate risk.
For Example, take a export oriented company that has entered into a swap deal for a notional
principal of USD 10 mn at an exchange rate of 53/dollar. The company pays US 6 months
LIBOR to the bank and receives 11.5% p.a. every 6 months on January 1, and July 1, for the next
5 years. This company would have earnings in Dollars and can use the same to pay off the
interest for this kind of borrowing, thus hedging its exposures.
FOREIGN DEBT: Foreign Debt can be used to hedge foreign exchange risk by taking
advantage of the International Fischer Effect relationship. According to International Fischer
Effect, an expected change in the current exchange rate between any two currencies is
approximately equivalent to the difference between the two countries‟ nominal interest rates for
that period of time. The rationale behind IFE is that a country with a higher interest rate will tend
to have a higher inflation rate. And this high amount of inflation should cause that country‟s
currency with the high interest rate to depreciate against a country with lower interest rates.
SUMMER INTERNSHIP, GAIL (INDIA) LIMITED, 2013 P a g e | 18
For Example, suppose an exporter is set to receive a fixed amount of Euros in a few months, say
6 months, the exporter will lose if the domestic currency appreciates against Euros in the interim,
so in order to hedge this, he can take a loan in Euros for 6 months and convert the same into
domestic currency at the existing exchange rate. According to this theory, the gain realized by
investing the proceeds from the loan taken would match the interest payment for the loan.
TECHNIQUES EMPLOYED:
A corporate depending upon the market situation may decide to use a technique or a set of
techniques to control their exposures. The techniques which are being by corporates are as
follows:
SUMMER INTERNSHIP, GAIL (INDIA) LIMITED, 2013 P a g e | 19
Figure 3.1: The different hedging techniques available to corporates to use.
Currency Futures: An agreement between two parties, to purchase/sell a currency at a future
date at a fixed price. In India, we are yet to have a futures exchange and clearing house for
financial futures, but in the west, currency futures trade on the futures exchange and are subject
to a daily settlement procedure to guarantee that each party that claims against the other party in
the contract will be paid.
Hedging Techniques
Currency Futures
Currency Options
Currency Swaps
Forward Currency
Transactions
Invoicing and Currency Clauses
Leads and Lags
Matching
Multi-lateral Netting
SUMMER INTERNSHIP, GAIL (INDIA) LIMITED, 2013 P a g e | 20
Currency Options: Currency options offer the right to the holder, not an obligation though, to
buy or sell foreign currency at an agreed (strike) price, within a specified period of time.
Exchange-traded options are present as well as OTC options.
Currency Swaps: A transaction between two parties in which they agree to an exchange of
payments over a specific time period. In a cross-currency swap, the parties exchange principals in
different currencies at an exchange rate prevalent at the time and reverse the exchange rate at a
later date, usually this is the same exchange rate prevalent when the currencies were first
exchanged.
Forward Currency Transactions: In this agreement the two parties agree to buy/sell a
currency at a later date at a fixed price. The advantage of such a contract is that you are protected
from an adverse movement in exchange rates as the exchange rate is locked in beforehand at an
agreed level.
Invoicing and Currency Clauses: In some cases, trading companies have the option to invoice
their cross-border sales/purchases in domestic currency, so that the other party involved absorbs
the exchange rate risk. Invoicing in third country currencies is also practiced. And sometimes
invoicing is done in terms of currency baskets, which consists of a composite index of different
world currencies are allotted predetermined weights.
Leads and Lags: The alteration of normal payment or receipts in a foreign exchange
transaction because of an expected change in exchange rate is known as leads and lags.
Accelerating the transactions is called „leads‟ which is done when firms making the payments
SUMMER INTERNSHIP, GAIL (INDIA) LIMITED, 2013 P a g e | 21
expect the foreign exchange rate to increase, whereas slowing down the transaction is known as
„lags‟ and arises when the exchange rate is expected to go down.
Matching: In cash flow matching, cash inflows in one of the pairing currencies can be
offset against cash flows in the other currencies. A corporate tries to balance its receivables and
payables in a currency. In order to achieve this, a short or long term loan or deposit may also be
undertaken.
Multi-lateral Netting: An agreement between multiple parties that transactions rather than
being settled individually be summed. This helps in streamlining the settlement process and also
reduces risk in the case of a default by making all the outstanding contracts null and void. The
disadvantage that it carries is that the risk is shared and the legalities that go with the agreement.
SUMMER INTERNSHIP, GAIL (INDIA) LIMITED, 2013 P a g e | 22
CHAPTER – 4
RESEARCH METHODOLOOGY
I. Policy Review
II. Compliance Appraisal
III. Variance Testing
Policy Review: The existing foreign exchange policy of the company was reviewed.
Compliance Appraisal: In this section, the accounting policy of the company is checked to
be in accordance to the IAS/IFRS standards.
Variance Testing: In this, random transactions were picked and were tested for their
congruence to the governing policy.
SUMMER INTERNSHIP, GAIL (INDIA) LIMITED, 2013 P a g e | 23
CHAPTER - 5
DATA ANALYSIS
OBJECTIVE OF IAS 21
The objective of IAS 21 is to prescribe how to include foreign currency transactions and foreign
operations in the financial statements of an entity and how to translate financial statements into a
presentation currency. The principal issues are which exchange rate(s) to use and how to report
the effects of changes in exchange rates in the financial statements.
BASIC STEPS FOR TRANSLATING FOREIGN CURRENCY AMOUNTS
INTO THE FUNCTIONAL CURRENCY:
Steps apply to a stand-alone entity, an entity with foreign operations (such as a parent with
foreign subsidiaries), or a foreign operation (such as a foreign subsidiary or branch).
1. the reporting entity determines its functional currency
2. the entity translates all foreign currency items into its functional currency
3. the entity reports the effects of such translation in accordance with paragraphs 20-37 [reporting
foreign currency transactions in the functional currency] and 50 [reporting the tax effects of
exchange differences].
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FOREIGN CURRENCY TRANSACTIONS:
A foreign currency transaction should be recorded initially at the rate of exchange at the date of
the transaction (use of averages is permitted if they are a reasonable approximation of actual).
[IAS 21.21-22]
At each subsequent balance sheet date: [IAS 21.23]
o foreign currency monetary amounts should be reported using the closing rate
o non-monetary items carried at historical cost should be reported using the exchange rate at
the date of the transaction
o non-monetary items carried at fair value should be reported at the rate that existed when the
fair values were determined
Exchange differences arising when monetary items are settled or when monetary items are
translated at rates different from those at which they were translated when initially recognised or
in previous financial statements are reported in profit or loss in the period, with one exception.
[IAS 21.28] The exception is that exchange differences arising on monetary items that form part
of the reporting entity's net investment in a foreign operation are recognised, in the consolidated
financial statements that include the foreign operation, in other comprehensive income; they will
be recognised in profit or loss on disposal of the net investment. [IAS 21.32]
As regards a monetary item that forms part of an entity's investment in a foreign operation, the
accounting treatment in consolidated financial statements should not be dependent on the
currency of the monetary item. [IAS 21.33] Also, the accounting should not depend on which
entity within the group conducts a transaction with the foreign operation. [IAS 21.15A] If a gain
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or loss on a non-monetary item is recognised in other comprehensive income (for example, a
property revaluation under IAS 16), any foreign exchange component of that gain or loss is also
recognised in other comprehensive income. [IAS 21.30]
TRANSLATION FROM THE FUNCTIONAL CURRENCY TO THE
PRESENTATION CURRENCY:
The results and financial position of an entity whose functional currency is not the currency of a
hyperinflationary economy are translated into a different presentation currency using the
following procedures: [IAS 21.39]
o assets and liabilities for each balance sheet presented (including comparatives) are translated
at the closing rate at the date of that balance sheet. This would include any goodwill arising
on the acquisition of a foreign operation and any fair value adjustments to the carrying
amounts of assets and liabilities arising on the acquisition of that foreign operation are treated
as part of the assets and liabilities of the foreign operation [IAS 21.47];
o income and expenses for each income statement (including comparatives) are translated at
exchange rates at the dates of the transactions; and
o all resulting exchange differences are recognised in other comprehensive income.
Special rules apply for translating the results and financial position of an entity whose functional
currency is the currency of a hyperinflationary economy into a different presentation currency.
[IAS 21.42-43]
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Where the foreign entity reports in the currency of a hyperinflationary economy, the financial
statements of the foreign entity should be restated as required by IAS 29 Financial Reporting in
Hyperinflationary Economies, before translation into the reporting currency. [IAS 21.36]
The requirements of IAS 21 regarding transactions and translation of financial statements should
be strictly applied in the changeover of the national currencies of participating Member States of
the European Union to the Euro – monetary assets and liabilities should continue to be translated
the closing rate, cumulative exchange differences should remain in equity and exchange
differences resulting from the translation of liabilities denominated in participating currencies
should not be included in the carrying amount of related assets. [SIC-7]
DISPOSAL OF A FOREIGN OPERATION:
When a foreign operation is disposed of, the cumulative amount of the exchange differences
recognised in other comprehensive income and accumulated in the separate component of equity
relating to that foreign operation shall be recognised in profit or loss when the gain or loss on
disposal is recognised. [IAS 21.48]
The company‟s foreign policy is in accordance to the required IAS21 norms.
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CHAPTER – 6
CONCLUSION
HEDGING IN PRACTICE IN THE INDIAN SCENARIO
INTRODUCTION
In this section we will see how the hedging is done by corporates plying their trade in the Indian
markets. We will see how the companies use Forward Contracts, Options, Swaps and also how
they manage Foreign Debts and much more. We will also deal with how the benchmarking and
monitoring is done by Indian Corporates.
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:
Genuine underlying exposures out of trade/business
Exposures due to foreign currency loans and bonds approved by RBI
Receipts from GDR issued
Balances in EEFC accounts
(II) Foreign Institutional Investors:
They should have exposures in India
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Hedge value not to exceed 15% of equity as of 31 March 1999 plus increase in
market value/ inflows
(III) Non−resident Indians/ Overseas Corporates:
Dividends from holdings in a Indian company
Deposits in FCNR and NRE accounts
Investments under portfolio scheme in accordance with FERA or FEMA
HEDGING IN PRACTICE
PERIOD TO CONSIDER
The first question that one is exposed to when we think of Foreign Exchange Hedging is what
exposures to include in terms of the period to consider. Most corporates in India follow a rolling
12 month basis with some following the rolling 6 month basis as well. According to this, all
exposures falling due for payment (interest and loan repayments included) considered on a rolling
12 or 6 month basis respectively.
PORTFOLIO OR NOT?
Another important aspect of Indian Corporates is that they manage the exposure on a portfolio
basis rather than on an individual basis. This is not to say that none of the Corporates manage the
exposures on an individual basis, but here we are going to be talking about hedging on a portfolio
basis.
Portfolio basis is a better way to manage exposures in the minds of the Corporates as, in the
presence of a large number of transactions it becomes difficult to keep track of the individual
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transactions. Managing exposures on a portfolio basis reduces the focus on individual
transactions and allows for a more holistic approach to risk management. The individual
transactions are included in the total transactions month-wise and managed accordingly on a
portfolio basis.
BENCHMARKING
A very important part of the Risk Management Process is the Benchmarking. In the Indian
markets usually stop loss levels are applied in relation to a benchmark and in ideal conditions the
benchmark should be the exchange rate used for costing, or for preparation of the corporate
budget, but these never serve as a practical benchmark because of the volatility of the exchange
rates which makes such a rate unrealistic in relation to market conditions when the exposure is
actually born.
Some companies use the forward exchange rate applicable to the maturity of an exposure, ruling
when the exposure is identified for risk management purposes plus the bank spread as the
benchmark.
In case of a foreign currency loan, if a hedge hasn‟t yet been taken, then the interest and principal
repayment amounts are included as an exposure if any payment falls within the next 12 months,
assuming that the firm applies a rolling 12 month basis with exposures. For Example, if there are
four exposures due in March 2014 of US$ 700,000 each which have been benchmarked at
different times at Rs.53 per $, Rs.54.75 per $, Rs.52 per $ and Rs.53.5 per $ respectively, then the
total portfolio of US$ 2.8 mn will have a benchmark average exchange rate of Rs.53.375 per $.
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As we said, the benchmark rates take into account the bank spreads, which may be as follows:
For US$ Exposures: 0.6 paise per $
For Non-US$ Exposures: 6 basis points (bps)
How are these spreads used by the corporates is as follows:
For Example, if a US$ 100 payable is due in June 2013 for which the forward rate existing on the
day the exposure is recognized is Rs.54.50 per $, then the benchmark rate for that particular 100
USD would become Rs.54.5060 per $.
Now for the currencies which are quoted on an indirect basis, it will be exercised as follows:
If a 100 EUR payable is due in June 2013 and the forward rate is US$ 1.40 per EUR, the
benchmark rate for the USD:EUR will be $ 1.4006 per EUR and the corresponding USD
exposure would be benchmarked at Rs.54.5060 per $.
PRINCIPLE OF STOP LOSS
There is the stop loss principle which is used by companies in order to protect the firm from the
adverse movements of the exchange rates. Here is how it works:
Suppose, if a future payable has been benchmarked at Rs.54 per $. It has been left unhedged in
the expectation of getting a more favorable exchange rate than Rs.54 (the favorable movement
will be appreciation in the INR). In case the rupee starts falling and the stop loss which had been
decided was say 200 paise per $, then such an exposure should be hedged when the ruling
forward rate for the payable in question goes to Rs.56 per $.
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This system protects the corporates in situations where there is adverse movement, but if the
movement is favorable they continue to benefit from it.
As we said companies apply benchmarking as a portfolio basis, So this is how the stop loss
system works in a portfolio situation:
Considering the previous example that we used of a US$ 2.8 mn payable which was
benchmarked at an average benchmark exchange rate of Rs.53.375 per $. If the company desires
to keep the portfolio loss less than or limited to Rs.42 lacs, then the entire portfolio should be
covered at an average rate of Rs.54.875 per $. Just in case one of those US$ 700,000 payables
have been benchmarked at Rs.52.175 per $, then the balance net open position must be hedged at
a maximum average rate of Rs.55.275 per $, in order to maintain the effective rate for the
exposure at Rs.54.875 per $.
CURRENCY OPTIONS
Now we will discuss how the corporates use the currency options to hedge their risks. In the
corporate scenario, an option contract is treated as an insurance contract – just as the best
insurance contract is the one on which no claim is made, the ideal option contract is the one
which is never exercised. The premium paid will be a dead loss, thus it is useful to consider
OTMF(Out of the Money) Forward Option Contracts( i.e. the strike rate is worse than the
existing forward rate) for risk management.
For Example, if a call option is taken to cover a payable which is due after 3 months at a strike
rate of Rs.56 per $, the premium payable would be say 90 paise per $. However if we use Rs.57,
the premium involved will come down to 50 paise per $. Since an option contract is taken by a
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corporate when it expects a favorable rate movement but wants to protect itself from the adverse
movement, it is better to pay the lower premium albeit at a worse strike rate.
Some corporates have a separate budget for the option premium to be paid. But any premium
paid for the benchmarked portion of the exposures would be a part of the portfolio loss.
CURRENCY FORWARDS
Now coming to Forward Contracts, they are usually used when an adverse exchange rate
movement is expected (rupee depreciation), whereas OTMF Option contracts are preferred when
a favorable exchange rate movement is expected. Forward or option contracts are usually not
taken for maturity exceeding that of the underlying exposure. Also, the total notional amount of
the forward and option contracts does not exceed the amount of the exposure.
Explaining this using an example, in April-August 2011 when the rupee was stable in a narrow
range for a long time and was expected to strengthen, an option contract would have been the
ideal choice- as long as the exchange rate remained range-bound one could benefit from the
stability, but when the rupee declined, the downside risk was limited.
A 3 month call option contract with a strike rate of Rs.46.25 per $ was available in mid-May
2011 at a cost of 54 paise per $. This wouldn‟t have been exercised in mid- August 2011 when
the spot rate was Rs.45.35 per $ to get an effective rate of Rs.45.89 per $. However a 3-month
call option contract with a strike rate of Rs.46.25 per $ was available in July 2011 at a premium
of 22 paise per $. This would have been exercised in October 2011 to get an effective rate of
Rs.46.47 per $ instead of the prevailing spot exchange rate of around Rs.49 per $.
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COMBINED STEP-UP HEDGING AND STAGGERED STOP LOSS
Another important technique used by corporates is the Combined Step-Up hedging and Staggered
Stop Loss, in this, the transactions in excess of a certain amount say US$ 10 mn instead of being
covered at a single stop loss level of say 180 paise worse than the forward rate, is covered by
using different stop loss levels. In this one-third of the transaction value is covered at the rate of
90 paise worse than the benchmark rate, another one-third of the transaction value at a rate of 180
paise worse than the benchmark rate and the balance at a rate of 270 paise worse than the
benchmark rate. Simultaneously, one-third of the transaction value is covered if the exchange rate
improves by 135 paise compared to the benchmark rate, another one-third when an improvement
of 270 paise takes place and the balance one-third when there is a gain of 405 paise over the
benchmark rate.
For Example, if a payable which is benchmarked at Rs. 53.50 per $, one third should be covered
if either Rs.52.15 or Rs.54.40 is available on the forward market, another one-third when
Rs.50.80 or Rs.55.30 is seen and the balance one-third when Rs.49.45 or Rs.56.20 is crossed. In
the end, the net overall open position is to be brought down to zero when the portfolio loss limit
is breached.
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OPEN POSITION AND STOP LOSS LEVELS
The maximum MTM portfolio loss is usually fixed at around 2% per quarter and 8% per annum
of the previous financial year‟s PAT. The limit is usually managed on quarterly basis. Once this
limit is crossed all the exposures are automatically hedged.
Then there might be limits put on transactions exceeding a certain amount, say US$ 6 mn. They
may be managed separately. The individual stop loss levels attached to them will be around 150
paise per $ for USD exposures and 3% for any other non-$ currency. Though these transactions
will be monitored separately they continue to be a part of the overall net open position limit. And
also the gain/loss incurred in these transactions will be a part of the portfolio loss limit.
MONITORING
Now comes the monitoring aspect of a treasury department. Usually the day to day forward rates
are monitored and compared to the benchmark. It might be done on a weekly basis or whatever
suits the corporate. The periodicity is usually increased whenever the portfolio loss for the
specified period exceeds say 40-50% of the allowed limit (depends on the risk appetite of the
corporate). Then there might be a limit of 80% post which reporting needs to be done to the
FRMC. In any case open position can‟t be kept once the portfolio loss exceeds 1.75% of the
previous financial year‟s PAT in a quarter.
In case there are uncertainities about maturities, hedging can be done for the latest possible
delivery date.
In case of a change in the delivery dates, the premium/discount prevailing on the date of change
should be adjusted in the existing benchmark. For example, If a USD payable has been
benchmarked for March at an exchange rate of Rs.55.25 per $. In March, it is postponed to June.
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Suppose the 3 month premium is 35 paise, the new benchmark for the very same exposure will
become Rs.55.60 per $.
BORROWINGS
A company with say a moderate approach to risk gives preference to rupee and foreign currency
borrowings, both short-term and medium-term almost in the same proportion as the cash flows in
different currencies. However, in general the foreign currency loan does not exceed 60% of the
total loans of the company.
A company avails debt in USD for following reasons:
1. Domestic inflation rate is, and is likely to remain, higher than in the U.S. which implies
that USD interest rates are likely to remain lower than for the Indian rupee. Thus,
borrowing in USD is cost effective from the interest cost angle.
2. Maintaining borrowings in the currency of cash flow (USD) also provides a hedge against
appreciation of the rupee against the invoicing currency.
3. If the rupee depreciates against the borrowed currency, this need not be a cause of
concern as the costlier debt servicing will be more than compensated by higher rupee
realization on the economic exposures.
RISK MANAGEMENT PROCESS
It completely depends upon the corporate if they want a part or whole of the exposure of Forex
loan be kept open, in the hope of gaining from profitable movement of exchange rate, the
company keeps a pre-determined stop loss level, which usually should not exceed the cost of
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rupee finance, and if this level is hit a hedge must be taken automatically. The desired stop loss
level should be decided by the FRMC.
For example, a USD $100 million loan drawn at an average exchange rate of Rs.50 and an
effective spread of 1.5% over USD LIBOR, had a fully hedged cost of 8% p.a. compared to a
rupee interest cost of 10% p.a. This rate of 10% would become the benchmark for short-term
exposures, since long-term exposures are susceptible to greater swings in exchange rates and
hedging costs.
An alternative strategy to this is to keep a graded stop loss limit. In this case, the cost of a fully
hedged foreign currency loan is say 8%p.a. and the alternative rupee finance is at say 13% p.a.
One-third of the loan amount should be hedged when the effective cost exceeds 11.5% (mid-
point), and a further one-third should be hedged when the effective cost becomes 113% p.a. and
14.5% p.a.
INTEREST RATE RISK
A loan at a fixed rate has an implicit opportunity cost (if interest rate falls, company would not be
able to take advantage of the low rate). A loan at a floating rate has the inherent risk of interest
rates moving up leading to a higher-than budgeted cost. The global best practice is to keep a mix
between fixed and floating rates such that a minimum 30% is at fixed rate, a minimum 30% of
the borrowing at floating rate, and only for the balance amount the Treasury can decide whether
to keep the loan at fixed or at floating rate.
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Interest rate risk is also managed by using interest rate caps and forward rate agreements (FRAs).
Caps are call options on the interest rate and limit the downside risk of an interest rate increase.
FRAs are forwards contracts on interest rates, and may be used in place of Interest Rate Swaps.
EEFC ACCOUNTS
Export Earners‟ Foreign Currency Accounts can be opened in relation to foreign currency
inflows. Hence, an EEFC account is opened for the foreign exchange receipts and payments. The
objective should be of matching receipts and payments in each currency as closely as possible in
order to eliminate transaction costs.
Given the two way movement of the rupee, there is little advantage in keeping large balances in
EEFC accounts with a view to profiting from exchange rate movements though.
SHORT-TERM FOREX FINANCE
This kind of finance is undertaken in order to take advantage of the lower cost of finance even on
a fully hedged basis. In such cases, a forward cover to hedge the exchange rate risk is taken in
order to ensure that the arbitrage opportunity by way of lower interest cost is locked into.
Hedging decisions should not be evaluated in retrospect. It could lead to misinterpretation even
speculation and also inappropriate to quantify loss or profit on the basis of cash flows
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CHAPTER – 7
BIBLIOGRAPHY
Investopedia
http://www.investopedia.com/
Wikipedia
http://www.wikipedia.org/
Asani Sarkar, Indian Derivatives Markets, Oxford Companion to Economics in India, 2006
pp 1-7
Reserve bank of India
http://www.rbi.org.in/Scripts/BS_FemaNotifications.aspx
Nevada Business
http://www.nevadabusiness.com/2013/04/risk-management-a-necessary-consideration/
V Skills
http://www.vskills.in/certification/article/foreign-exchange-risk-management-
%E2%80%93-importance-external-treasury-management-solutions-smes
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Deloitte IAS Plus
http://www.iasplus.com/en/standards/ias21