Study On Currency Risks Handled By Indian Firm Finance Essay - Free Essay Example

Sample details Pages: 10 Words: 3000 Downloads: 6 Date added: 2017/06/26 Category Finance Essay Type Cause and effect essay Did you like this example? The objective of this project is to examine how the impacts of currency exchange risks are dealt by the Indian Firms. Currency Exchange Risk in Global Market is a burning issue for any firm or corporate involved in business overseas. In this scenario, India is of course the one country where we have a lot of scope to focus on as far as the study of currency risk in business is concerned. Don’t waste time! Our writers will create an original "Study On Currency Risks Handled By Indian Firm Finance Essay" essay for you Create order If we see the world wide scenario, the financial sector is facing a lot of adjustment problems in the rapid changes in the economic financial environment. Now Indian financial system cannot be indifferent to this universal phenomenon. I would like to take the example of the Indian IT giants with special emphasis on TCS, in this exploratory paper to see how the currency swings affected the business of TCS in last couple of years and would try to provide some supportive data to show the same. It is very interesting to see how the companies like TCS uses different derivative instruments to keep the sustainability of its performance in the financial market by hedging the financial risks, specially related to the volatility of the money market and foreign currency exchange rates. How Companies use Derivatives for Hedging Risk Management Hedging Hedging, in simple words, says controlling or reducing risk. This controlling or reducing risk is done by taking a position in th e futures market that is opposite to the one in the physical market with an objective to reduce or limit risks associated with price changes. A simple example will help us understand it better. A wheat farmer can sell wheat futures to protect the value of his crop prior to harvest. If there is a fall in price, the loss in the cash market position will be countered by a gain in futures position. 2.2. Derivatives Derivatives are those financial instruments whose values depend on the value of not only the underlying financial instruments but on any underlying asset. We can take the same example of the wheat farmer. Here, the wheat farmer can protect itself of any fall in price by entering into a contract with the merchant. Some of the derivative instruments are: Futures, Swap, Options, and Forwards. To summarize, Hedging can be defined as a method where one can reduce the financial exposure faced in an underlying asset due to volatility in prices by taking an opposite position in the derivatives market in order to off-set the losses in the cash market by a corresponding gain in the derivatives market. This above definition captures the basic essence of derivatives hedging. Now having understood the basic meaning of hedging and derivatives, we would now see how corporate use these derivative instruments for hedging. 2.3. Foreign Exchange Risks The most common corporate uses of derivatives is for hedging foreign-currency risk, or foreign exchange risk, which is the risk that a change in currency exchange rates adversely impacts business results. Lets consider an example with Infosys Technologies, a multi-national IT company which even exports soft wares to other countries, and mainly to US. Lets make an assumption that Infosys Technologies exports software worth 1000 Crores to US in 2006-07 when the price of per US Dollar was at Rs. 40 (assumption). When the rupee per dollar exchange rate increases from Rs. 40, Rs. 42, Rs. 44, it takes more rupees to buy one dollar, meaning the rupee is depreciating or weakening. As the rupee depreciates, the softwares which Infosys exports would translate into greater sales in rupee terms. This demonstrates how a weakening rupee is not all that bad: it can boost export sales of Indian companies. Now lets illustrate a simple hedge that a company like Infosys Technologies might us e to minimize the effects of any Rupee / USD exchange rates, Infosys purchases 2000 foreign-exchange futures contracts against the Rupee / USD exchange rate. The value of the futures contracts will not, in practice, correspond exactly on a 1:1 basis with a change in the current exchange rate (that is, the futures rate wont change exactly with the spot rate), but we will assume that it does anyway. Each futures contract has a value equal to the gain above the Rs. 40 Rupee/USD rate. (Only because Infosys took this side of the futures position, somebody the counter-party will take the opposite position.) Of course, its not a free lunch: If the strategy of Infosys goes against it, that is, if the dollar were to weaken instead, then the increased export sales are mitigated (partially offset) by losses on the futures contract. 2.4. Hedging Interest Rate Risks Companies can hedge interest-rate risks in various ways. Consider a company that expects to sell a division in one year and at that time to receive a cash wind-fall that it wants to park in a good risk-free investment or a company had an unexpected profit, if the company strongly believes that interest rates will drop between now and then, it could purchase (or take a long position on) a treasury futures contract. The company is effectively locking in the future interest rate. Fair Value Hedges The Company [XYZ] had two interest rate swaps outstanding at January 1, 2008 designated as a hedge of the fair value of a portion of fixed-rate bonds. The change in fair value of the swaps exactly offsets the change in fair value of the hedged debt, with no net impact on earnings. XYZ Company uses an interest rate swap. Before it entered into the swap, it was paying a variable interest rate on some of its bonds. (For example, a common arrangement would be to pay LIBOR plus something a nd to reset the rate every six months.) Now lets look at the impact of the swap, the swap requires XYZ to pay a fixed rate of interest while receiving floating-rate payments. The received floating-rate payments are used to pay the pre-existing floating-rate debt. XYZ is then left only with the floating-rate debt, and has. Therefore, managed to convert a variable-rate obligation into a fixed-rate obligation with the addition of a derivative. Here we can call this as a perfect hedge: The variable-rate coupons that XYZ received compensates for the companys variable-rate obligation. 2.5. Commodity or Product Input Hedge Companies that depend heavily on raw-material inputs or commodities are sensitive, sometimes significantly, to the price change of the inputs. Airlines, for example, consume lots of jet fuel. Historically, most airlines have given a great deal of consideration to hedging against crude-oil price increases although they need to be very careful and a great forecasting before going for such a strategy because the strategy itself would cost them a lot. As we reviewed here three of the most popular types of corporate hedging with derivatives. There are many other derivative uses, and new types are being invented. The derivatives that are reviewed are not generally speculative for the company. They help protect the company from unanticipated events: adverse foreign-exchange or interest-rate movements, and unexpected increases in input costs. The investor on the other side of the derivative transaction is the speculator. However, in no case are these derivatives free. Even if, for exam ple, the company is surprised with a good-news event like a favorable interest-rate move, the company (because it had to pay for the derivatives) receives less on a net basis than it would have without the hedge. Warren Buffetts stand is famous: he has attacked all derivatives, saying he and his company view them as time bombs, both for the parties that deal in them and the economic system. Foreign Exchange Risk Management Firms dealing with multiple currencies face risk in terms of unanticipated gain/loss on account of sudden/unanticipated changes in exchange rates, quantified in terms of exposures. Exposure is defined as a contracted, projected or contingent cash flow whose magnitude is not certain at the moment and depends on the value of the foreign exchange rates. The process of identifying risks faced by the firm and implementing the process of protection from these risks by financial or operational hedging is defined as foreign exchange risk management. My paper limi ts its scope to hedging only the foreign exchange risks faced by firms like TCS. 3.1. Kinds of Foreign Exchange Exposure Risk management techniques vary with the type of exposure (accounting or economic) and term of exposure. Accounting exposure, also called translation exposure, results from the need to restate foreign subsidiaries financial statements into the parents reporting currency and is the sensitivity of net income to the variation in the exchange rate between a foreign subsidiary and its parent. Economic exposure is the extent to which a firms market value, in any particular currency, is sensitive to unexpected changes in foreign currency. Currency fluctuations affect the value of the firms operating cash flows, income statement, and competitive position, hence market share and stock price. Currency fluctuations also affect a firms balance sheet by changing the value of the firms assets and liabilities, accounts payable, accounts receivables, inventory, loans in foreign currency, investments (CDs) in foreign banks; this type of economic exposure is called balance sheet exposure. Transactio n Exposure is a form of short term economic exposure due to fixed price contracting in an atmosphere of exchange-rate volatility. The most common definition of the measure of exchange-rate exposure is the sensitivity of the value of the firm, proxied by the firms stock return, to an unanticipated change in an exchange rate. This is calculated by using the partial derivative function where the dependant variable is the firms value and the independent variable is the exchange rate (Adler and Dumas, 1984). 3.2. Necessity of managing foreign exchange risk A key assumption in the concept of foreign exchange risk is that exchange rate changes are not predictable and that this is determined by how efficient the markets for foreign exchange are. Research in the area of efficiency of foreign exchange markets has thus far been able to establish only a weak form of the efficient market hypothesis conclusively which implies that successive changes in exchange rates cannot be predicted by analyzing the historical sequence of exchange rates.(Soenen,1979). However, when the efficient market theory is applied to the foreign exchange market under floating exchange rates there is some evidence to suggest that the present prices properly reflect all available information (Giddy and Dufey, 1992). This implies that exchange rates react to new information in an immediate and unbiased fashion, so that no one party can make a profit by this information and in any case, information on direction of the rates arrives randomly so exchange rates also fluctu ate randomly. It implies that foreign exchange risk management cannot be done away with by employing resources to predict exchange rate changes. 3.3. Foreign Exchange Risk Management Framework Once a firm recognizes its exposure, it then has to deploy resources in managing it. A heuristic for firms to manage this risk effectively is presented below which can be modified to suit firm-specific needs i.e. some or all the following tools could be used. Forecasts: After determining its exposure, the first step for a firm is to develop a forecast on the market trends and what the main direction/trend is going to be on the foreign exchange rates. The period for forecasts is typically 6 months. It is important to base the forecasts on valid assumptions. Along with identifying trends, a probability should be estimated for the forecast coming true as well as how much the change would be. Risk Estimation: Based on the forecast, a measure of the Value at Risk (the actual profit or loss for a move in rates according to the forecast) and the probability of this risk should be ascertained. The risk that a transaction would fail due to market-specific problems4 should be taken int o account. Finally, the Systems Risk that can arise due to inadequacies such as reporting gaps and implementation gaps in the firms exposure management system should be estimated. Benchmarking: Given the exposures and the risk estimates, the firm has to set its limits for handling foreign exchange exposure. The firm also has to decide whether to manage its exposures on a cost centre or profit centre basis. A cost centre approach is a defensive one and the main aim is ensure that cash flows of a firm are not adversely affected beyond a point. A profit centre approach on the other hand is a more aggressive approach where the firm decides to generate a net profit on its exposure over time. Hedging: Based on the limits a firm set for itself to manage exposure, the firms then decides an appropriate hedging strategy. There are various financial instruments available for the firm to choose from: futures, forwards, options and swaps and issue of foreign debt. Hedging strategies and in struments are explored in a section. Stop Loss: The firms risk management decisions are based on forecasts which are but estimates of reasonably unpredictable trends. It is imperative to have stop loss arrangements in order to rescue the firm if the forecasts turn out wrong. For this, there should be certain monitoring systems in place to detect critical levels in the foreign exchange rates for appropriate measure to be taken. Reporting and Review: Risk management policies are typically subjected to review based on periodic reporting. The reports mainly include profit/ loss status on open contracts after marking to market, the actual exchange/ interest rate achieved on each exposure, and profitability vis-Ã  -vis the benchmark and the expected changes in overall exposure due to forecasted exchange/ interest rate movements. The review analyses whether the benchmarks set are valid and effective in controlling the exposures, what the market trends are and finally whether the ove rall strategy is working or needs change. Figure 1: Framework for Risk Management Effect of Currency swings in Indian market Cross-currency volatility is gnawing at the profit margins of almost every tech company. The movement of non-dollar currencies has undone the gains from rupees downward movement against the US dollar. When Indian IT companies were first exposed to the rupee-dollar volatility in 2007 (that time the Indian currency was strengthening against the greenback), they had hedged themselves against the dollar. However, while the rupee movement reversed again, IT companies and their CFOs were caught off guard as other currencies showed unexpected volatility for which they had very little hedges in place. As per the research and news: Indias total trade now accounts for over 40% of its GDP, and this highlights the increasing openness of the Indian economy and its reliance on foreign trade. However, as companies revenues increasingly come from cross-border trad e, they also become more vulnerable to fluctuations and swings in currency rates. There are many such examples amongst the Indian business. A midsize iron ore manufacturer and exporter suffered losses to the tune of $9.5 million due to adverse currency movements and losses of derivative transactions, which caused its profitability to slump to 4.5% as compared with 15% in the previous year. In another example, a mid-size auto component manufacturer suffered exchange losses of $1.2 million in the fiscal year ended March 31, 2009. This was because the company did not have a foreign exchange (forex) strategy in place to proactively counter this risk. It has now started hedging on selective basis by way of plain vanilla forwards as a corrective step. Looking at the cases like these, companies are now stepping up their cross-currency hedges. Example of TCS As per the annual report of TCS in the year 2007-2008, we get the following details, which reflect the derivative instr uments used by TCS to hedge the forex risk. Derivative financial instruments The Company, in accordance with its risk management policies and procedures, enters into foreign currency forward contracts and currency option contracts to manage its exposure in foreign exchange rates. The counter party is generally a bank. These contracts are for a period between one day and eight years. The Company has following outstanding derivative instruments as on March 31, 2008: The following are outstanding Foreign Exchange Forward contracts, which have been designated as Cash Flow Hedges, as on: Â Â March 31,2008 Â Â Â March 31,2007 Â Foreign Currency No. of Contracts Notional amount of forward contracts (million) Fair Value (Rs. In crores) Â No. of Contract Notional amount of forward contracts (million) Fair Value (Rs. In crores) Â Gain/(Loss) Â Gain/(Loss) U.S.Dollar 14 290 25.21 Â Sterling Pound 3 15 3.91 Â 5 21 0.32 Euro 3 19 11.78 Â Â Â 0.35 The following are outstanding Currency Option contracts, which have been designated as Cash Flow Hedges, as on: Â Â March 31,2008 Â Â Â March 31,2007 Â Foreign Currency No. of Contracts Notional amount of forward contracts (million) Fair Value (Rs. In crores) Â No. of Contract Notional amount of forward contracts (million) Fair Value (Rs. In crores) Â Gain/(Loss) Â Gain/(Loss) U.S.Dollar 67 3871.50 (88.70) Â 27 830.00 32.71 Sterling Pound 7 55.65 (2.23) Â 5 47.50 (1.93) Euro 12 99.25 (38.75) Â 11 76.50 (0.60) Net loss on derivative instruments of Rs.21.83 crores recognized in Hedging Reserve as of March 31, 2008, is expected to be reclassified to the profit and loss account by March 31, 2009 The movement in Hedging Reserve during year ended March 2008, for derivatives designated as Cash Flow Hedges is as follows: Particulars Year ended March 31, 2008 Year ended March 31, 2007 Â (Rs. In crores) (Rs. In crores) Balance at the beginning of the year 73.71 4.42 Gains / (losses) transferred to income statement on occurrence of forecasted hedge transaction 64.91 4.42 Changes in the fair value of effective portion of outstanding cash flow derivatives 174.78 29.64 Net derivative gain/(losses) related to a discontinued cash flow hedge 150.83 44.07 Balance at the end of the year 15.15 73.71 In addition to the above cash flow hedges, the Company has outstanding foreign exchange forward contracts and currency option contracts aggregating Rs. 2167.95 crores (previous year : Rs.2062.61 crores), whose fair value showed a loss of Rs.4.46 crores as on March 31, 2008 (previous year : gain of Rs 6.76 crores), to hedge the future cash flows. Although these contracts are effective as hedges from an economic perspective, they do not qualify for hedge accounting and accordingly these are accounted as derivatives instruments at fair value with changes in fair value recorded in the profit and loss account. Exchange gain of Rs.283.96 crores (previous year gain of Rs.45.13 crores) on foreign exchange forward contracts and currency option contracts have been recognized in the year ended March 31, 2008.