Foreign Exchange Hedging Tools

FOREIGN CURRENCY HEDGING TOOLS

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Contents……...

� Meaning of Hedging

� Currency Hedging

� Generic Hedging Decision Tree

� Types of Currency Exposure

� What is Exposure and Risk?

� Hedging Tools

� Examples of Hedging in Indian Companies

� Case Study


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What is the meaning

of Hedging?

An important tool in the global

financial markets, hedging is used in

every asset class to mitigate losses.

This can be utilised by anyone,

whether it is an individual or

corporates, to overcome the negative

impact of price volatility.

For the corporates in which the

business activity is dependent on

import and export of commodities,

there is an automatic exposure to

foreign exchange and, hence, the

need for hedging is higher. In the

current context, since the world

markets are interlinked, they

eventually affect and impact the

movement of currencies.

Hedging, in any asset class, is

ultimately a strategy to decrease or

transfer risk in order to protect one's

portfolio or business from

uncertainty in prices. In case of

hedging in the foreign exchange

market, a participant who is entering

a trade with the intention of

protecting the existing position from

an unexpected currency move, is said

to have created a forex hedge.

The strategy to create a hedge

would depend on the following

parameters:

(a) risk component

(b) risk tolerance and

(c) to plan and execute the strategy.

Why the need for hedging ?

Hedging is a preventive strategy used by individual investors or companies

to protect their portfolio from adverse currency, interest rate, or price

movements and is aimed specifically at reducing any uncertainty in the

market. The hedge ratio is explained as the percentage of the position in an

asset that is hedged using derivatives. Some see hedgers as risk averse

individuals. However, we see hedgers as risk neutral individuals as they

choose their hedging strategy based on the expected value (return) of any given

strategy. To better justify ourview of hedgers being risk neutral individuals


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Currency or Forex

Hedging?

Currency movement hedge is used by

international companies or investors

that hold an international portfolio. A

currency movement hedge allows

hedgers to manage and minimize

their exposure to any adverse

exchange rate movement. Note that

it is only the currency movement

hedge that will be the focus of this

thesis.

International businesses are naturally

exposed to currency risk. With the

rapid integration of the global

economy, many efforts have been

directed to study those risks

associated with exchange rate.

Transaction risk and translation risk

are the two most commonly

discussed currency risks for

international businesses. Transaction

risk can be defined as the impact of

unexpected changes in the exchange

rate on the cash flow arising from all

contractual relationships. On the

other hand, translation risk refers to

the risks which arise from the

translation of the value of an asset

from a foreign currency to the

domestic currency.

Authors, such as Mannino and Milani

(1992), Hollein (2002), and

Homaifar(2004, p.217), also defined

translation risk as the change in book

value of assets and liabilities,

excluding stockholders’ equity as

residuals, due to changes in the

foreign exchange rate. International

companies that trade and receive

revenue in foreign currencies

would incur translation risk. The most

common cases of companies

experiencing translation risk are

when overseas subsidiaries translate

the subsidiaries’ balance sheet and

income statements into the

functional currency of the parent

companies for consolidation and

reporting purposes as required by

legislations. During this translation

process, movement in the exchange

rate can produce accounting gains or

losses that are posted to the

stockholders’ equity

Transaction risk and Translation risk

are the two most commonly

discussed currency risks for

international businesses strategy.


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We believe the

common view of

hedging can be

summarized as

follows

(1) Hedging is one of the three most

fundamental reasons for the

existence of the financial market,

alongside speculative and arbitrage

activities

(2) The hedging industry is evolving

just like the rest of the business

world. Infact, there is no definite set

of tools or technique that can define

hedging. Asthe world changes, new

hedging mechanisms are derived; and

as time passes, these mechanisms are

refined and evolve into something

new that can be better applied to the

contemporary commercial

marketplace

(3) Hedging is not a way of making

money, but to assist management in

better managing corporate revenue

through reducing the corporate

exposure to volatility in the foreign

currency markets

(4) When used prudently, hedging

can be effective insurance as well as a

value-enhancing exercise for

corporations. Effective hedging

programs have been proven to allow

corporations to minimize or transfer

their foreign currency exposure. The

diminished exposure to foreign

currency fluctuations allows more

stable and predictable cash-flows,

notably in terms of revenue. As a

result, firms are then capable of

making more comprehensive

financial plans, including more

reliable estimations on tax, income

after tax and dividends payable to

shareholders. It is believed that a

dividend payout is often of significant

appeal to long-term, current or

prospective shareholders

The ideal result for a hedge

would be to cause a “seesaw effect”

where one effect will cancel out

another. Because of this “seesaw

effect”, hedging not only protects

companies from any losses that may

occur due to an adverse market, but

also restricts companies

from any gains if the market goes in

favor of the companies. The three

main questions surrounding

hedging: when, what and how to

hedge are explained further


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Generic Hedging Decision Tree

When to Hedge?

Under

Currency

Risk

Exposure

When to Hedge?

Hedge

No

Hedge

Hedge Ratio

• 10%

• 50%

• 100%

OR

• Any ratio

between

0.1% - 99%

Fully

participating

market

movements

How to Hedge?

?

Financial Tools

1. Forward

2. SWAP

3. Money

Market

4. Futures

5. Options

6. Leveraged

Spot

Non-Financial

Tools

1. Leading

2. Lagging


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Types of Currency Exposure

Currency Exposure

Long-Term

Operating

Exposure

Strategic

Exposure

Short-Term

Accounting

(Translation

Exposure)

Cash Flow

Anticipated

Changes

Unanticipated

Changes

(Transactions

exposure)


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What is Exposure,

Risk – are they same?

Each firm is “exposed” to

unforeseen changes in a number

of variables in its environment.

These variables are called Risk

Factors. E.g. Exchange rate

fluctuation is a risk factor.

EXPOSURE:It is the measure of the

sensitivity of a firm’s performance

to fluctuations in the relevant risk

factor i.e. whether or not a certain

risk factor affects a firms

performance.

RISK:It is the measure of the

extent of variability of the

performance attributable to the

risk factor i.e. how much does a

risk factor affect a firms

performance.

Different types of Exposure-

• Transaction exposure

• Translation exposure

• Operating exposure

Hedging tools could be chosen depending on the type of exposure.

For example, between April 1992 and July 1995 the exchange rate between

rupee and US dollar was rock steady. For an Indian firm involved in exports

and imports from US, this meant that it had significant exposure to this

exchange rate (because the exchange rate could have affected its

performance) but it did not perceive significant risk because the exchange

rate was stable.


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Translation exposure, also called Accounting

Exposure or Balance Sheet exposure, arises because

financial statements of Foreign subsidiaries – which

are stated in foreign currency – must be restated in

the parent’s reporting currency for the firm to

prepare consolidated financial statements.

Translation exposure is the potential for an increase

or decrease in the parent’s net worth and reported

net income caused by a change in exchange rates

since the last translation.

The accounting process of translation, involves

converting these foreign subsidiaries financial

statements into home currency-denominated

statements. It is the exposure on assets and

liabilities appearing in the balance sheet but

which are not going to be liquidated in the

foreseeable future. It has no direct impact on

cash flows of a firm.

An Example An Indian Company with a U.k. subsidiary

Particular

March 31, 2012

(£1=Rs85)

March 31, 2013

(£1=Rs70)

Value in £ Translated value Value in £ Translated value

Real Estate £1,000,000 Rs 85,000,000 £950,000 Rs 66,500,000

Inventories £200,000 Rs 17,000,000 £250,000 Rs 17,500,000

Cash £150,000 Rs 12,750,000 £160,000 Rs 11,200,000


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Total £1,350,000 Rs 102,000,000 £1,360,000 Rs 95,200,000

Transaction Exposure: The risk, faced by companies

involved in international trade, that currency

exchange rates will change after the companies have

already entered into financial obligations. It stems

from the possibility of incurring exchange gains or

losses on transactions already entered into and

denominated in a foreign currency. Transaction

exposure is short term in nature.

It has a direct impact on cash flows of a firm.

An Example

Thus, exposure is the chance of either a loss or a gain

Suppose a U.S. firm, Trident, sells merchandise on account to a Belgian buyer for €1,800,000 payment to be

made in 60 days. (S0 = $0.90/€)

The U.S. seller expects to exchange the €1,800,000 for $1,620,000 when payment is received.

Transaction exposure arises because of the risk that the U.S. seller will receive something other than

$1,620,000.

If the euro weakens to $0.8500/€, then Trident will receive $1,530,000

If the euro strengthens to $0.9600/€, then Trident will receive $1,728,000


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Operating exposure, also called economic

exposure, competitive exposure, and even

strategic exposure on occasion, measures any

change in the present value of a firm resulting

from changes in future operating cash flows

caused by an unexpected change in exchange

rates.

Measuring the operating exposure of a firm

requires forecasting and analyzing all the firm’s

future individual transaction exposures together

with the future exposures of all the firm’s

competitors and potential competitors worldwide.

Operating exposure is far more important for the

long-run health of a business than changes caused

by transaction or translation exposure.


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Hedging Tools………

Forwards: A forward is a made-to-

measure agreement between two

parties to buy/sell a specified amount

of a currency at a specified rate on a

particular date in the future. The

depreciation of the receivable

currency is hedged against by selling

a currency forward. If the risk is that

of a currency appreciation (if the firm

has to buy that currency in future say

for import), it can hedge by buying

the currency forward.

Futures: A futures contract is similar

to the forward contract but is more

liquid because it is traded in an

organized exchange i.e. the futures

market. Depreciation of a currency

can be hedged by selling futures and

appreciation can be hedged by

buying futures. Advantages of futures

are that there is a central market for

futures which eliminates the problem

of double coincidence. Futures

require a small initial outlay (a

proportion of the value of the future)

with which significant amounts of

money can be gained or lost

with the actual forwards price

fluctuations. This provides a sort of

leverage.

Example: if RIL wants to buy crude oil in US dollars six months hence, it can

enter into a forward contract to pay INR and buy USD and lock in a fixed

exchange rate for INR-USD to be paid after 6 months regardless of the actual

INR-Dollar rate at the time. In this example the downside is an appreciation of

Dollar which is protected by a fixed forward contract. The main advantage of a

forward is that it can be tailored to the specific needs of the firm and an exact

hedge can be obtained. On the downside, these contracts are not marketable,

they can’t be sold to another party when they are no longer required and are

binding.

Example: The previous example for a forward contract for RIL applies here also

just that RIL will have to go to a USD futures exchange to purchase standardised

dollar futures equal to the amount to be hedged as the risk is that of

appreciation of the dollar. As mentioned earlier, the tailorability of the futures

contract is limited i.e. only standard denominations of money can be bought

instead of the exact amounts that are bought in forward contracts


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Options: A currency Option is a

contract giving the right, not the

obligation, to buy or sell a specific

quantity of one foreign currency in

exchange for another at a fixed price;

called the Exercise Price or Strike

Price. The fixed nature of the exercise

price reduces the uncertainty of

exchange rate changes and limits the

losses of open currency positions.

Options are particularly

suited as a hedging tool for

contingent cash flows, as is the case

in bidding processes. Call Options are

used if the risk is an upward trend in

price (of the currency), while Put

Options are used if the risk is a

downward trend

Swaps: A swap is a foreign currency

contract whereby the buyer and

seller exchange equal initial principal

amounts of two different currencies

at the spot rate. The buyer and seller

exchange fixed or floating rate

interest payments in their respective

swapped currencies over the term of

the contract. At maturity, the

principal amount is effectively re-

swapped at a predetermined

exchange rate so that the parties end

up with their original currencies. The

advantages of swaps are that firms

with limited appetite for exchange

rate risk may move to a partially or

completely hedged position through

the mechanism of foreign currency

swaps, while leaving the underlying

borrowing intact. Apart from covering

the exchange rate risk, swaps also

allow firms to hedge the floating

interest rate risk.

Example of RIL which needs to purchase crude oil in USD in 6 months, if RIL

buys a Call option (as the risk is an upward trend in dollar rate), i.e. the right to

buy a specified amount of dollars at a fixed rate on a specified date, there are

two scenarios. If the exchange rate movement is favourable i.e the dollar

depreciates, then RIL can buy them at the spot rate as they have become

cheaper. In the other case, if the dollar appreciates compared to today’s spot

rate, RIL can exercise the option to purchase it at the agreed strike price. In

either case RIL benefits by paying the lower price to purchase the dollar


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v

Money Market: The money market

and forward market are identical

because interest rate parity holds. So

hedging in the money market is like

hedging in the forward market. A

money market hedge also includes a

contract and a source of funds to

fulfill the contract. Those hedgers

who use money market hedges

borrow in one currency and convert

the borrowing into another currency.

We have included a discussion on the

mechanism of hedging using the

money market in

Leveraged Spot Market: The

leveraged spot contract is

fundamentally the same as a spot

contract. The only difference

between the leveraged spot contract

and a spot contract is the leverage

ratio available in all leveraged spot

contracts. The leverage ratio can

range from twenty (1:20) to two

hundred (1:200), and is specified by

the trading financial institutions. This

leverage ratio is a powerful feature of

the leveraged spot contracts. Indeed,

if the leverage ratio is twenty (1:20),

this means that the leveraged spot

contract trader will have access to a

credit line twenty times larger than

his/her initial collateral. It is obvious

that this distinct feature of the

leveraged spot contracts will allow

traders to trade at a significantly

lower capital requirement when

compared to the spot market.

.

Example: Consider an export oriented company that has entered into a swap for

a notional principal of USD 1 mn at an exchange rate of 42/dollar. The company

pays US 6months LIBOR to the bank and receives 11.00% p.a. every 6 months on

1st January & 1st July, till 5 years. Such a company would have earnings in

Dollars and can use the same to pay interest for this kind of borrowing (in

dollars rather than in Rupee) thus hedging its exposures

Example: Indeed, the mechanism of trading a leveraged spot contract involves

borrowing a certain amount of money from a country, say, Japan, for a specific

period at a specific interest rate, then converting the amount of Japanese yen

into another currency, say, the Australian dollar, at the existing spot rate and

investing the Australian dollar in the Australian money market at the Australian

interest rate, and finally converting the Australian dollar back to Japanese yen

to repay the Japanese yen borrowing.


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Examples of Hedging by Indian Companies

SUN PHARMA (as on 31st march 2014)

Type of contract

Currency Buy/sell Cross currency

Amt (in millions)

Nature of

exposure

Forward contract

USD

Sell Rs

USD 240

Exporter of

generic

drugs.

Forward contract

USD

Sell NIS USD 41

Forward contract

USD

Sell CAD USD 65.3

Cross currency

swaps

NIS

Buy

USD

USD 9.1

Interest rate swaps

(floating to fixed)

USD

Sell USD

USD 7.8


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MARUTI SUZUKI (AS ON 31ST MARCH 2015)

Type of contract Currency/commodity Buy/sell Cross

currency

Amt (Rs in millions) Nature of

exposure

Forward contract

against imports

USD Buy Rs Nil Borrowings in

JPY. Also,

metals that are

imported are

hedged.

Forward contract

against imports

JPY Buy USD 7575

Forward contract

against imports

Euro Buy USD 882

Forward contract

against exports

USD Sell Rs 2279

Forward contract

against commodities

Platinum - - 305

Forward contract

against commodities

Palladium - - 221

Forward contract

against commodities

Lead - - 153


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Case Studies

HCL TECH CASE STUDY - 2008

This case study provides in depth understanding of the situation in which HCL

Tech suffered huge foreign exchange losses and the measures taken by the

company to overcome from it. In addition to this, the case study provides the

views of stock broking houses and analysts on the decisions taken by HCL Tech.

INTRODUCTION

HCL Tech, a leading global IT player, had a presence in 18 countries at 60 locations

all over the world. It was the fifth largest Indian IT player as of 2008 with a 3%

contribution in the IT-ITES sector. It provided a wide range of IT-related products

and services to mid- and large size enterprises all over the world with the help of

more than 50,000 employees...

FOREX STRATEGY FOLLOWED BY HClTECH

As a major part of HCL Tech's revenue was generated from outside India, the cash

flows of the company were influenced by currency movements. The company

therefore used derivative financial instruments like foreign currency forwards to

hedge its currency risk for a certain forecasted period...

FLUCTUATIONS IN FX MARKET

The Indian Rupee (INR) recorded its strongest mark against the US Dollar (USD) in

November 2007 at Rs. 39, having strengthened by around 11% from Rs. 44 per

dollar at the beginning of the year 2007. The strengthening of the Indian Rupee

was mainly due to the depreciation in the USD. The depreciation was mainly due

to the slowdown in the US economy, high spending on wars, and the negative

balance of payment in the US. In the same year, foreign capital investment in

India increased...

IMPACT OF FX FLUCTUATIONS ON HCL TECH

HCL Tech took the forward hedge covers for the next coming 7 to 10 quarters,

depending upon the earnings visibility and forex market. As the rupee


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appreciated from Rs. 44.27 per dollar in January 2007 to Rs. 39.45 per dollar in

November 2007, HCL Tech reported a huge forex gain as it had already covered its

revenues at around Rs. 44 per dollar...

STEPS TAKEN BY HCL TECH

As the company reported on a mark-to-market basis, the gains or losses occurring

from the forward hedge covers of future quarter revenues caused huge

fluctuations in its reported profits. This also created a mismatch between the

reported revenues and the forex losses/gains...

FUTURE OUTLOOK

With the cancellation of currency hedges, industry analysts opined that the

company's move toward unhedged currency forwards reflected its expectations

that the rupee would depreciate against the dollar and sustain at Rs. 47 to Rs. 50

in the short to medium term. But they wondered what the company’s position

would be if the rupee appreciated above Rs.47 against the dollar...


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WOCKHARDT - CASE STUDY – 2008

Life after debt

(This article appeared in The Economic Times, India Edition dated 17th August 2010)

Last year, a trusted lieutenant of Habil Khorakiwala dialled a Singapore number to

contact a gentleman named Ponty Singh. Mr Singh, a former banker with Morgan

Stanley and Citi, owns the financial services firm Tricolor Capital. The conversation

that followed was the first of its kind by an official of an Indian company.

Wockhardt, the company that Mr Khorakiwala founded in 1967, was sitting on a

mountain of losses — nearly 1,500 crore — after a series of cross-currency

derivative deals with banks backfired. These are complex transactions that the

pharma firm had done to get a better exchange rate — so that its export earnings

generate more when converted into rupees — and possibly convert a slice of its

expensive local loans into cheaper foreign currency credit with a lower interest

rate.

All that was possible with the magic of derivatives — a wonderworld that many

small Indian companies had stepped into and later burnt their fingers when

currency markets moved against them.

But Wockhardt was not a textile outfit in the backyard of Tirupur. It was a

closelytracked company with solid brands, research centres and manufacturing

facilities in half a dozen countries. But fortunes reversed between February 2008

and the first quarter of 2009. And one day, Wockhardt looked like a basket case.

Debts had ballooned from Rs 1,000 crore to Rs 3,500 crore, bankers were asking

for money, analysts downgraded the stock and deal-makers were snooping

around for a possible buyout. While there was good cash flow from Wockhardt’s

regular businesses, which were growing, the money wasn’t enough to meet the

payouts that kept mounting. Indian companies and bankers had never

experienced something like this. Corporate America is full of stories of derivative

hits, with stuff like the $157-million loss of Procter & Gamble in the 90s now a

part of B-school textbooks. In May 2009, Wockhardt’s loss on derivatives was

double of that, at $300 million.


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Ponty Singh’s job was to evaluate the deals, assess how fair these transactions

were and how valid were the claims made by highstreet lenders, which included

banks like Calyon, Barclays, Deutsche, JP Morgan, ABN Amro, HSBC, Citi,

StanChart, DBS of Singapore and BNP. Another firm Numerics was roped in to

analyse the data. The findings by Tricolor formed the contours of a defence that

Wockhardt had put up in multiple court feuds in India and abroad. Some of these

were complex transactions: for instance Wockhardt EU had cut deals with

offshore banks against guarantees from Wockhardt Ltd, the Indian parent.

The guarantee was invoked abroad while a winding up petition was moved in the

Bombay High Court. Besides derivatives, other liabilities that troubled the

company were: $110-million foreign currency convertible bonds, which were not

converted into equity as the stock never touched the price that was fixed —

something Wockhardt had not expected and was being forced to pay back — and,

a large foreign currency loan to fund overseas acquisition.

Strangely, the debt hurdle looks less formidable today. Wockhardt’s bankers and

other creditors have been left frustrated, and almost driven to a point where they

are willing to accept any settlement terms. The company has sorted out the dues

with some of the derivative banks and is talking to creditors like Calyon, Barclays

and QVT — the offshore fund that invested in the convertible bonds.

Under the settlement, the derivative banks will get only 25% of what they

claimed, while QVT is being offered a deal that’s significantly better (for

Wockhardt) than what the fund had earlier proposed. Chances are QVT will go for

it. Though Syndicate Bank, one of the FCCB investors, is pushing Wockhardt to

clear its dues before it finalises the deal with QVT, bankers think the company

may be close to ending its debt woes.

What helped? Mr Khorakiwala and his team of advisors were quick to spot that

derivative outstandings, like FCCBs, were similar to personal loans or credit card

dues. They were unsecured and there was no recourse for banks but to move

courts. There was also another element. It lay in the complexity of derivatives.

Wockhardt argued that banks had missold complex products, never spoke about

the downsides and the contracts were wagers or pure bets that violated the laws


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of the land. The cases dragged on in courts whose introduction to derivatives has

been recent.

And, local lenders, who have been Wockhardt’s bankers for years, tossed a

lifeline: led by ICICI and SBI, domestic banks came together to rejig the loans and

gave a priority loan of 500 crore to pay back some of the foreign derivative banks.

The combined hit for banks would be 1,000 crore. Meanwhile, the company’s

promoters chipped in 70 crore as part of the deal. Till the derivative and some of

the other liabilities are fully settled — something that could take a good part of

the year — the company’s bottomline will continue to bleed.

A few months ago, Wockhardt’s deal to sell its nutrition business, which owns

brands like Farex and Protienx, to Abbott Labs fell through. `The lenders opposed

it’ was the official explanation but many felt that Wockhardt was fishing for a

better price as things looked up. As the tide turns, the company will again look for

a buyer. The Wockhardt story, which captures the nasty surprises of the currency

market, the vulnerability of bankers, and ruthless negotiating skills of a company

close to the brink, will possibly go down as a case study for students in corporate

finance.

These days Wockhardt stays away from hedging. It shuns even deals like simple

forward contracts. Maybe, it demonstrates the firm’s aversion to step into an

unpredictable foreign exchange market. Or, perhaps it reflects banks reluctance

to deal with a party that has given much grief. But the company seems to have

picked up a few lessons. Some of the officials, who dealt with the derivative

banks, have been sacked. And visitors to Mr Khorakiwala’s office are occasionally

given a photocopy of the book ‘Traders, Guns & Money — Knowns & Unknowns

in the Dazzling World of Derivatives’.


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Sources:

Annual Report of Sun Pharma

Annual Report of Maruti

Various News Articles

Foreign Exchange Hedging and Profit Making Strategy using Leveraged Spot Contracts

CHING HSUEH LIU

Victoria Graduate School of Business

Faculty of Business and Law

Corporate Hedging for Foreign Exchange Risk in India

Submitted by:

Anuradha Sivakumar and Runa Sarkar

Industrial and Management Engineering Department

Indian Institute of Technology, Kanpur

SMBA Batch 34,

Prashant M

Shital P

Karunakar N

Rinki H

Shahzad S

Theresa T


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Economy & Finance

Foreign Exchange Hedging Tools