Question

outline of a paper on hedging and managing currency and foreign exchange risk for international businesses

Answer 1

Abstract and Figures

The continuing liberalization of Indian economy has resulted in extensive inflow of foreign capital into India. High economic growth and capital account liberalization led to increased currency exposures of both domestic entities and foreign counterparts, leading to a rise in the demand for risk management instruments for hedging exposure linked to real and financial flows. This volatility in financial markets requires investors (individual as well as corporate) to be aware of the risks associated with currency fluctuations and the use of Foreign Exchange derivatives market for minimizing the risks due to exposure to foreign currencies. Most individual and corporate investors use currency derivatives for effectively managing their foreign exchange exposures. This research paper focuses on the various alternatives available to the Indian corporate for hedging financial risks and the perceptions, apprehensions and expectations of common investors who are investing/ would be investing in currency derivatives market.

Introduction

Each country has its own currency through which both national and international transactions are performed. All the international business transactions involve an exchange of one currency for another. If any Indian firm borrows funds from international financial market in US dollars for short or long term then at maturity the same would be refunded in particular agreed currency along with accrued interest on borrowed money. It means that the borrowed foreign currency brought in the country will be converted into Indian currency, and when borrowed funds are paid to the lender then the home currency will be converted into foreign lender’s currency. Thus, the currency units of a country involve an exchange of one currency for another.

Foreign Exchange Risk Management

Exchange rate risk management is an integral part of every firm’s decisions about foreign currency exposure (Allayannis et al., 2001).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 termed as foreign exchange risk management. In risk management of the underlying assets using financial derivatives, the basic strategy is Hedging i.e., the trader holds two positions of equal amounts but opposite directions, one in the underlying markets, and the other in the derivatives markets, simultaneously. Currency risk hedging strategies entail eliminating or reducing this risk, and require understanding of both the ways that the exchange rate risk could affect the operations of economic agents and techniques to deal with the consequent risk implications

Hedging Strategies/ Instruments

A derivative is a financial contract whose value is derived from the value of some other financial asset, such as a stock price, a commodity price, an exchange rate, an interest rate, or even an index of prices. The main role of derivatives is that they reallocate risk among financial market participants, help to make financial markets more complete.

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. For example, if Reliance Industries Limited (RIL) wants to buy crude oil in US dollars six months hence, it can enter into a forward contract to pay INR (Indian Rupee) and buy USD (US Dollar) 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

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

Options:

A currency Option is a contract giving the right, not the obligation, to buy or sell aspecific quantity of one foreign currency in exchange for another at a fixed price; called theExercise 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. Again taking the 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 favorable 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

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. 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 and 1st July, till 5 years. Such a company would haveearnings in Dollars and can use the same to pay interest for this kind of borrowing (in dollarsrather than in Rupee) ,thus hedging its exposures

Foreign Debt:

Foreign debt can be used to hedge foreign exchange exposure by taking advantage of the International Fischer Effect relationship. This is demonstrated with the example of an exporter who has to receive a fixed amount of dollars in a few months from present. The exporter stands to lose if the domestic currency appreciates against that currency in the meanwhile, so to hedge this he could take a loan in the foreign currency for the same time period and convert the same into domestic currency at the current exchange rate. The theory assures that the gain realized by investing the proceeds from the loan would match the interest rate payment (in the foreign currency) for the loan.

The recent period has witnessed amplified volatility in the INR-US exchange rates in the backdrop of the sub-prime crisis in the US and increased dollar-inflows into the Indian stock markets. In this context, the paper has attempted to study the choice of instruments adopted by prominent firms to stem their foreign exchange exposures. All the data for this has been compiled from the 2010-2011 Annual Reports of the respective companies

Conclusion

In the current scenario, investing in derivative markets is a major challenge ever for the investors. Currency Derivatives acts as a major tool for hedging the risk caused by exchange rate fluctuations. This study identifies that a perception with majority of investors is that currency derivatives trading can be used for hedging, particularly. The nature of the derivatives instruments are to reduce the risk involved in trading so real time investors are taking currency derivatives trading for reducing their risk involved in trading and making profits and they considered these to be important factors for making investment. The investors should be made aware of the various hedging and speculation strategies, which can be used for reducing their risk. Awareness about the various uses of currency derivatives can help investors to reduce risk and increase profits as the lack of knowledge appears to be the most significant barrier to investors that prevents the investors from investing.