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Hedging Of Forex Exposure through Currency Derivatives-Evidence From select

Indian corporate

Presented by:
Gnyana Ranjan Bal 1st year student
Pondicherry University

Electronic copy available at:

Hedging Of Forex Exposure through Currency Derivatives-Evidence From select

Indian corporate
Gnyana Ranjan Bal

To save Indian economy from collapse, in the year 1991 policy of globalization and liberalization were
introduced in India. As a corollary trade barriers were also removed. It resulted into integration of domestic
economy with world economy and there was substantial into flow (in and out) of capital crossing the border
of the nation. However the free flow of capital and free trade exposed the Indian corporate enterprises to a
higher foreign currency risk. To avoid huge loss caused by foreign exchange volatility, the currency
derivatives in Indian Financial market were introduced. In the year 1999, Reserve Bank of India introduced
Currency forwards, National Stock Exchange also launched the platform for trading in currency futures in
2008 and trading in Currency Options in 2010. The Indian firms were given the opportunities to effectively
manage the foreign exchange risk exposure and to hedge their foreign exchange risk by using the currency
derivatives. This paper attempts to evaluate the various alternatives available to the Indian corporate for
hedging financial risks and this has been evaluated in select corporate enterprises.

Electronic copy available at:

1. Introduction:
In 1971, the Bretton Woods system of administering fixed foreign exchange rates was abolished and a
regime of fluctuating exchange rates was introduced to determine foreign exchange rates. And another
reason is due to high volatility in other markets around the world causes to increased inflation and the oil
shock. Corporate faced many problems in maintaining a healthy profit due to uncertainty in profits, cash
flows and future costs. During that period financial derivatives foreign currency, interest rate, and
commodity derivatives emerged to managing risks facing corporations in the some parts of world.
After introduction of Economic Policy of 1991; India moved from closed economy to opened economy. The
past regulated exchange rate was abolished and market determined exchange rate regime was introduced in
1993.Thus the Rupee was made fully convertible in current account. Demand and supply conditions now
govern the exchange rates in our foreign exchange market. Multi-national corporations are playing
increasingly important roles in Indian market and there has been a sharp increase in foreign investment in
India. The transactions between Indian corporate and foreign corporate increased. Indian firms have also
been more active in raising financial resources abroad. All these developments combine increases crosscurrency cash flows, involving different currencies and different countries. The Indian corporate houses in
India are felt the need for organised fund management. This leads to application of hedging techniques for
protecting Indian companies against future uncertain foreign exchange risk exposure. Derivatives tools were
used to deal with foreign exchange risk exposure.
a. To study the Hedging instruments available to Indian corporate
b. To know the how Indian corporate are implementing hedging through currency derivatives.
3. Literature Review
In the year 1985 Collier and Davis had made a study about the organisation and practice of currency risk
management by multi-national companies of U.K. They found those MNC were following centralised
control of group currency risk management and formal exposure management policies. They were activily
managing their risk of currency transactions. In the year 1992 the study of practice of foreign exchange risk
management and product usage of Australia based firms by Batten, Metlor and Wan. Among the 72 firms
they had in their study around 70% firms were attempted to get maximum returns by trading their foreign
exchange exposures and acting as foreign exchange risk bearer. Transaction exposure emerged as the most
relevant exposure. In 1993 Jesswein et al had made a study on use of derivatives by U.S. corporations. He
categorises foreign exchange risk management products under three generations.(1)First Generation;
includes Forward contracts,(2) Second Generation includes Futures, Options, Futures- Options, Warranties
and Swaps and(3)Third Generation includes Range, Compound Options, Synthetic Products and Foreign
Exchange Agreements .

In his Study the result showed that the use of the third generation products was

generally less than that of the second-generation products, which was, in turn, less than the use of the first
generation products. Here the size of company had not significant impact on use risk management product;
however it was significantly related to the companys degree of international involvement. In the Year 1995

Phillips had made a study by focusing on derivative securities and derivative contracts. He concludes that
financial risk exposures were faced by organisations of all sizes.

In the year 1998 the pattern of use of derivatives by a large number of U.S firms was studied by Howton
and Perfect. In this study it was found that 60% of firms used some type of derivatives contract while only
36% of the randomly selected firms used derivatives. In both types of firms over 90% of the interest rate
contracts were swaps, while over 80% of currency contracts were futures and forward contracts. In the
comparison made by Hentschel and Kothari (2000) between the risk exposure of derivative users and the
risk exposure of nonusers, it was found that economically small differences in equity return volatility
between derivative users and nonusers. They also find that currency hedging has little effect on the currency
exposure of firms' equity, even though derivatives use ranges from 0.6% to 64.2% of the firm's assets. In the
year 2010 Dr. Hiren M Maniar in his paper Hedging of Foreign Exchange Risk by corporate in India
presented at 6th finance conference at Portugal had made a study on different hedging instruments available
to Indian corporate. And in the paper corporate hedging of foreign exchange risk in India by Anuradha
Sivakumar and Runa Sarkar had made a study hedging instruments used by Indian corporate for short term
and long term hedging and hedging instruments available to corporate in India.
4. Foreign Exchange Risk Management Framework
Once a firm recognizes its exposure, it then has to deploy resources in managing it. The factors which fall
within the framework for management of foreign exchange risk include:
4.1. Forecasts: After determining its exposure, the first step for a firm is to forecast the market trends and
what the main direction/trend is going to be on the foreign exchange rates. Typically 6 months can be taken
as a base period for forecast. Valid assumptions should be taken while forecasting. After identifying trends,
a probability should be estimated for the forecast coming true as well as how much the change would be.
4.2. Risk Estimation: Based on the forecast, value at risk should be measured along with the probability of
this risk. Value at risk means the actual profit or loss for a move in rates according to the forecast. The risk
that a transaction would fail due to market-specific problems should be taken into account. Sometimes the
Systematic Risk can be arise due to inadequacies such as reporting gaps and implementation gaps in the
firms exposure management system. That should be estimated.
4.3. 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.
4.4. Hedging: Firm should decide suitable hedging technique as per the limits a firm set for itself to manage
Forex risk. There are various types of financial instruments available for the firm to choose from: futures,
forwards, options and swaps.

4.5. Stop Loss: All the risk management decisions are taken by firms based on forecasts which are but
estimates of reasonably unpredictable trends. It is better to have stop loss arrangements in order to save 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.
4.6. 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--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 overall strategy is working or needs change.
5. Hedging Techniques.
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 defined as foreign exchange
risk management.
5.1. 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. E.g. if
IOC 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 cant be sold to another party when they are no longer required and are binding.
5.2. 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 IOC applies here also just that IOC 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.

5.3. 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. Again taking the example of IOC
which needs to purchase crude oil in USD in 6 months, if IOC 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 IOC
can buy them at the spot rate as they have become cheaper. In the other case, if the dollar appreciates
compared to todays spot rate, IOC can exercise the option to purchase it at the agreed strike price. In either
case IOC benefits by paying the lower price to purchase the dollar.
5.4. 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 & 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.
The following factors are affected the decisions of firms in selection the instruments. There is conclusive
evidence to suggest that firms with larger size, R&D expenditure and exposure to exchange rates through
foreign sales and foreign trade are more likely to use derivatives. After deciding the instruments firms has to
take into consideration the factor affecting the amount of hedging. The following mentioned points are
affecting the decision to hedge:6.1. Firm size: Firm size acts as a proxy for the cost of hedging or economies of Scale. Risk management
involves fixed costs of setting up of computer Systems and training/hiring of personnel in foreign exchange
management. Moreover, large firms might be considered as more creditworthy Counterparties for forward or
swap transactions, thus further reducing their Cost of hedging. The book value of assets is used as a measure
of firm size.
6.2. Leverage: According to the risk management literature, it is more useful for firms with high Leverage
have to go for hedging in order to reduce the probability of risks.

6.3. Liquidity and profitability: Firms with highly liquid assets or high Profitability are less interested to
engage in hedging their probability of financial distress is less. Liquidity can be measured by liquid ratio
(i.e. Quick assets/Current liabilities).
6.4. Sales growth: Sales growth is a factor determining decision to hedge as Opportunities are more likely
to be affected by the underinvestment problem. For these firms, hedging will reduce the probability of
having to rely on External financing, which is costly for information asymmetry reasons, and thus enable
them to enjoy uninterrupted high growth.
Evidence of Derivative use for Hedging Foreign exchange Risk by Corporate in India.
The following table has given as an evidence for implementation of Hedging Techniques by some Indian
Table 1: Evidence of Derivative use for Hedging of Forex Risk by Corporate in India



Nature of exposure

Currency swaps


Option contracts


Forward contracts


Earnings in all businesses are

linked to
USD. The key input, crude oil is
Purchased in USD. All export
are in foreign currency and local
are based on import parity prices

Reliance Industries

as well
Maruti Udyog
Forward Contracts

6411 (INR-JPY)
70 ($-INR)

Import/Royalty payable in Yen and

Exports Receivables in dollars.

Currency swaps

124.70(USD -INR)

Interest rate and forex risk

Forward Contracts

350 (INR-JPY)

Trade payables in Yen and Euro

Export receivables in dollars.

Currency Swaps

5390 (JPY-INR)

Interest rate and foreign exchange

Mahindra and Mahindra

Forward Contracts

119 ($-INR)


Options Contracts
Range barrier options

4 ($-INR)
8 (INR-$)
2 ($-INR)
3 (Euro-INR


Revenues denominated in these


Tata Consultancy Services

Forward Contracts

15 (Euro-INR)

Revenues largely denominated in




foreign currency, predominantly

GBP and Euro. Other currencies
Australian $, Canadian $, South
Rand, and Swiss Franc

8 3 0 ($-INR)
47.5 (Euro-INR)
76.5 (GBP-INR)

Forward Contracts


Exposed on accounts receivable

Loans payable. Exposure in USD
Jap Yen

Special evidence of IOCL and Infosys

Hedging at Indian Oil Corporation Ltd. (IOCL)
At IOCL more than 90% purchases are imports and near about 5% of the sales are from exports. The
Company has a high foreign currency exposure. The Foreign Exchange Risk Management as reported in the
Annual Report for 2010 -11 of the company reveals:
(a)Unhedged Foreign Currency Exposure is INR 40,765 crore.
(b)Hedged by 20 forward contracts is INR 3,030 crore.
Hedging at Infosys: As on 31st march 2011 the outstanding amount of forward contracts was

2433 crore INR

In Euro

177 crore INR


108 crore INR

In Aud

46 crore INR

But no option contract out standing was there, while the option contract outstanding in USD as on 31st
march 2010 was 898 crore INR.

7. Conclusion
The present paper examines the hedging position of above stated Indian corporate which are having diverse
trade links with rest of world with special focus on variety of hedging instruments to hedge the risk arising
from currency fluctuations. The instruments include currency swaps, futures, forwards and options which
are extensively used by Indian corporate. After assessing the present hedging position of Indian companies
present study recommends the use of diverse hedging strategies like range, bilateral netting and invoice
billing, Compound Options, Synthetic Products and Foreign Exchange Agreements. The IOCL, being oil
marketing company has a higher foreign currency exposure. In the volatile forex market the company has a
large proportion of unhedged foreign currency exposure and the small amount of exposure hedged is only
through Forward Contracts. Considering the management of foreign currency risk at IOCL, one of the
highly foreign exchange exposed company, it can be concluded the Indian companies need to increase the
efficiency in managing the foreign currency exposure. And in case of Infosys as maximum portion of
revenue has been generated from other nations therefore hedging through currency derivatives has become
the part of their routine operation. Generally the greatest hindrances to Indian companies are legal restraints
by various regulatory authorities within as well as outside the country. Through my work I came to a
conclusion that Indian corporate have shown upward trend in using forwards for hedging their foreign
exchange risk. So it can be concluded that corporate in India require to become more efficient in managing
their forex risk arises due to currency fluctuations.

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