FOREIGN CURRENCY HEDGING TOOLS

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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Hedging, in any asset class, is

What is the meaning ultimately a strategy to decrease or
transfer risk in order to protect one's
of Hedging? portfolio or business from
uncertainty in prices. In case of
An important tool in the global
hedging in the foreign exchange
financial markets, hedging is used in
market, a participant who is entering
every asset class to mitigate losses.
a trade with the intention of
This can be utilised by anyone,
protecting the existing position from
whether it is an individual or
an unexpected currency move, is said
corporates, to overcome the negative
to have created a forex hedge.
impact of price volatility.

For the corporates in which the The strategy to create a hedge

business activity is dependent on would depend on the following
import and export of commodities, parameters:
there is an automatic exposure to
foreign exchange and, hence, the (a) risk component
need for hedging is higher. In the
current context, since the world (b) risk tolerance and
markets are interlinked, they
eventually affect and impact the (c) to plan and execute the strategy.
movement of currencies.

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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Authors, such as Mannino and Milani

Currency or Forex (1992), Hollein (2002), and
Hedging? Homaifar(2004, p.217), also defined
translation risk as the change in book
value of assets and liabilities,
Currency movement hedge is used by
excluding stockholders’ equity as
international companies or investors
residuals, due to changes in the
that hold an international portfolio. A
foreign exchange rate. International
currency movement hedge allows
companies that trade and receive
hedgers to manage and minimize
revenue in foreign currencies
their exposure to any adverse
would incur translation risk. The most
exchange rate movement. Note that
common cases of companies
it is only the currency movement
experiencing translation risk are
hedge that will be the focus of this
when overseas subsidiaries translate
thesis.
the subsidiaries’ balance sheet and
income statements into the
International businesses are naturally
functional currency of the parent
exposed to currency risk. With the
companies for consolidation and
rapid integration of the global
reporting purposes as required by
economy, many efforts have been
legislations. During this translation
directed to study those risks
process, movement in the exchange
associated with exchange rate.
rate can produce accounting gains or
Transaction risk and translation risk
losses that are posted to the
are the two most commonly
stockholders’ equity
discussed currency risks for
international businesses. Transaction
risk can be defined as the impact of
unexpected changes in the exchange Transaction risk and Translation risk
rate on the cash flow arising from all are the two most commonly
contractual relationships. On the discussed currency risks for
other hand, translation risk refers to international businesses strategy.
the risks which arise from the
translation of the value of an asset
from a foreign currency to the
domestic currency.

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value-enhancing exercise for

corporations. Effective hedging
We believe the programs have been proven to allow
common view of corporations to minimize or transfer
their foreign currency exposure. The
hedging can be diminished exposure to foreign
currency fluctuations allows more
summarized as stable and predictable cash-flows,
follows notably in terms of revenue. As a
result, firms are then capable of
making more comprehensive
(1) Hedging is one of the three most
financial plans, including more
fundamental reasons for the
reliable estimations on tax, income
existence of the financial market,
after tax and dividends payable to
alongside speculative and arbitrage
shareholders. It is believed that a
activities
dividend payout is often of significant
appeal to long-term, current or
(2) The hedging industry is evolving
prospective shareholders
just like the rest of the business
world. Infact, there is no definite set
of tools or technique that can define The ideal result for a hedge
would be to cause a “seesaw effect”
hedging. Asthe world changes, new
where one effect will cancel out
hedging mechanisms are derived; and
another. Because of this “seesaw
as time passes, these mechanisms are
effect”, hedging not only protects
refined and evolve into something
companies from any losses that may
new that can be better applied to the
occur due to an adverse market, but
contemporary commercial
also restricts companies
marketplace
from any gains if the market goes in
favor of the companies. The three
(3) Hedging is not a way of making
main questions surrounding
money, but to assist management in
hedging: when, what and how to
better managing corporate revenue
hedge are explained further
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
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 FOREIGN CURRENCY HEDGING TOOLS

Generic Hedging Decision Tree

When to Hedge? How to Hedge?

When to Hedge? Hedge Ratio Financial Tools

Hedge ?
• 10% 1. Forward
• 50% 2. SWAP
• 100% 3. Money
OR Market
Under 4. Futures
• Any ratio
Currency 5. Options
between
Risk 6. Leveraged
0.1% - 99%
Exposure Spot

Non-Financial
Tools
No Fully
Hedge 1. Leading
participating
2. Lagging
market
movements

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Types of Currency Exposure

Currency Exposure

Short-Term Long-Term

Accounting
(Translation Cash Flow Operating
Exposure) Exposure

Strategic
Anticipated Unanticipated Exposure
Changes Changes
(Transactions
exposure)

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to fluctuations in the relevant risk

What is Exposure, factor i.e. whether or not a certain
Risk – are they same? risk factor affects a firms
performance.
Each firm is “exposed” to
RISK:It is the measure of the
unforeseen changes in a number
extent of variability of the
of variables in its environment.
performance attributable to the
These variables are called Risk
risk factor i.e. how much does a
Factors. E.g. Exchange rate
risk factor affect a firms
fluctuation is a risk factor.
performance.
EXPOSURE:It is the measure of the
sensitivity of a firm’s performance

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.

Different types of Exposure-

• Transaction exposure

• Translation exposure

• Operating exposure

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

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Translation exposure, also called Accounting The accounting process of translation, involves
Exposure or Balance Sheet exposure, arises because converting these foreign subsidiaries financial
financial statements of Foreign subsidiaries – which statements into home currency-denominated
are stated in foreign currency – must be restated in statements. It is the exposure on assets and
the parent’s reporting currency for the firm to liabilities appearing in the balance sheet but
prepare consolidated financial statements. which are not going to be liquidated in the
foreseeable future. It has no direct impact on
Translation exposure is the potential for an increase cash flows of a firm.
or decrease in the parent’s net worth and reported
net income caused by a change in exchange rates
since the last translation.

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

March 31, 2012 March 31, 2013

Particular (£1=Rs85) (£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 losses on transactions already entered into and
involved in international trade, that currency denominated in a foreign currency. Transaction
exchange rates will change after the companies have exposure is short term in nature.
already entered into financial obligations. It stems
It has a direct impact on cash flows of a firm.
from the possibility of incurring exchange gains or
An Example
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

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

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Operating exposure, also called economic requires forecasting and analyzing all the firm’s
exposure, competitive exposure, and even future individual transaction exposures together
strategic exposure on occasion, measures any with the future exposures of all the firm’s
change in the present value of a firm resulting competitors and potential competitors worldwide.
from changes in future operating cash flows
Operating exposure is far more important for the
caused by an unexpected change in exchange
long-run health of a business than changes caused
rates.
by transaction or translation exposure.
Measuring the operating exposure of a firm

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Hedging Tools………
Forwards: A forward is a made-to- currency is hedged against by selling
measure agreement between two a currency forward. If the risk is that
parties to buy/sell a specified amount of a currency appreciation (if the firm
of a currency at a specified rate on a has to buy that currency in future say
particular date in the future. The for import), it can hedge by buying
depreciation of the receivable the currency forward.

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.

Futures: A futures contract is similar of double coincidence. Futures

to the forward contract but is more require a small initial outlay (a
liquid because it is traded in an proportion of the value of the future)
organized exchange i.e. the futures with which significant amounts of
market. Depreciation of a currency money can be gained or lost
can be hedged by selling futures and with the actual forwards price
appreciation can be hedged by fluctuations. This provides a sort of
buying futures. Advantages of futures leverage.
are that there is a central market for
futures which eliminates the problem

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 Options are particularly

contract giving the right, not the suited as a hedging tool for
obligation, to buy or sell a specific contingent cash flows, as is the case
quantity of one foreign currency in in bidding processes. Call Options are
exchange for another at a fixed price; used if the risk is an upward trend in
called the Exercise Price or Strike price (of the currency), while Put
Price. The fixed nature of the exercise Options are used if the risk is a
price reduces the uncertainty of downward trend
exchange rate changes and limits the
losses of open currency positions.

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

Swaps: A swap is a foreign currency up with their original currencies. The

contract whereby the buyer and advantages of swaps are that firms
seller exchange equal initial principal with limited appetite for exchange
amounts of two different currencies rate risk may move to a partially or
at the spot rate. The buyer and seller completely hedged position through
exchange fixed or floating rate the mechanism of foreign currency
interest payments in their respective swaps, while leaving the underlying
swapped currencies over the term of borrowing intact. Apart from covering
the contract. At maturity, the the exchange rate risk, swaps also
principal amount is effectively re- allow firms to hedge the floating
swapped at a predetermined interest rate risk.
exchange rate so that the parties end

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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
v
Dollars and can use the same to pay interest for this kind of borrowing (in
dollars rather than in Rupee) thus hedging its exposures

Money Market: The money market borrow in one currency and convert
and forward market are identical the borrowing into another currency.
because interest rate parity holds. So We have included a discussion on the
hedging in the money market is like mechanism of hedging using the
hedging in the forward market. A money market in
money market hedge also includes a
contract and a source of funds to
fulfill the contract. Those hedgers
who use money market hedges

Leveraged Spot Market: The the leveraged spot contracts. Indeed,

leveraged spot contract is if the leverage ratio is twenty (1:20),
fundamentally the same as a spot this means that the leveraged spot
contract. The only difference contract trader will have access to a
between the leveraged spot contract credit line twenty times larger than
and a spot contract is the leverage his/her initial collateral. It is obvious
ratio available in all leveraged spot that this distinct feature of the
contracts. The leverage ratio can leveraged spot contracts will allow
range from twenty (1:20) to two traders to trade at a significantly
hundred (1:200), and is specified by lower capital requirement when
the trading financial institutions. This compared to the spot market.
leverage ratio is a powerful feature of
.
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 NIS Buy USD USD 9.1

swaps

Interest rate swaps USD Sell USD USD 7.8

(floating to fixed)

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MARUTI SUZUKI (AS ON 31ST MARCH 2015)

Type of contract Currency/commodity Buy/sell Cross Amt (Rs in millions) Nature of
currency exposure
Forward contract USD Buy Rs Nil Borrowings in
against imports JPY. Also,
Forward contract JPY Buy USD 7575 metals that are
against imports imported are
hedged.
Forward contract Euro Buy USD 882
against imports
Forward contract USD Sell Rs 2279
against exports

Forward contract Platinum - - 305

against commodities

Forward contract Palladium - - 221

against commodities
Forward contract Lead - - 153
against commodities

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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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